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 email@example.com.
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 firstname.lastname@example.org 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.
SEC approves consolidated FINRA rules governing Know Your Customer (Rule 2090) and Suitability Obligations (Rule 2111), effective October 7, 2011.
Know Your Customer
In general, new FINRA Rule 2090 (Know Your Customer) is modeled after former NYSE Rule 405(1) and requires firms to use “reasonable diligence,” in regard to the opening and maintenance of every account, to know the “essential facts” concerning every customer.6The 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.” The know-your-customer obligation arises at the beginning of the customer-broker relationship and does not depend on whether the broker has made a recommendation. Unlike former NYSE Rule 405, the new rule does not specifically address orders, supervision or account opening—areas that are explicitly covered by other rules.
New FINRA Rule 2111 generally is modeled after former NASD Rule 2310 (Suitability) and 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.” The rule further explains that a “customer’s investment profile includes, but is not limited to, the 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.” The new rule continues to use a broker’s “recommendation” as the triggering event for application of the rule and continues to apply a flexible “facts and circumstances” approach to determining what communications constitute such a recommendation. The new rule also applies to recommended investment strategies, clarifies the types of information that brokers must attempt to obtain and analyze, and discusses the three main suitability obligations. Finally, the new rule modifies the institutional-investor exemption in a number of important ways.
FINRA Regulatory Notice 11-02, which discusses the consolidated rules continues on to discuss the determination of the existence of a recommendation, explicitly state the application to investment strategies involving securities, inclusion of an expanded list of explicit types of information to gather and analyze as part of the suitability analysis (adding age, investment experience, time horizon, liquidity needs and risk tolerance to the existing list of other holdings, financial situation and needs, tax status and investment objectives, lists three main suitability obligations: reasonable-basis, customer-specific and quantitative suitability and provides an exemption to customer-specific suitability for recommendations to institutional customers under certain circumstances.
Please contact our firm if you need assistance modifying your written supervisory procedures, new client forms or other securities, regulatory or arbitration related legal advice at email@example.com.
On January 25, 2011, the Securities and Exchange Commission proposed a revised net worth standard as required under the Dodd-Frank Street Reform and Consumer Protection Act in Securities Act Release Number 9177. The SEC has requested comments by March 11, 2011. The link above is a summary of the important proposals of the SEC’s Release 9177, in particular the proposed amendment to the definition of accredited investor. For a summary of the release, please go to our resources section of the website. For the full text, please visit the Securities and Exchange Commission’s site.
The SEC Division of Trading and Markets extended, but amended by increasing the conditions, for broker-dealers relying on registered investment advisers to perform customer identification program (“CIP”) requirements. On January 11, 2011, the SEC agreed to extend for two years the position taken in a 2004 No-Action Letter (and subsequent extensions in 2005, 2006, 2008 and 2010), which permitted broker-dealers to rely upon registered investment advisers to perform CIP as a result of the Securities Industry and Financial Market Association’s request for No-Action relief on behalf of its member broker-dealers. Section 326 of the USA PATRIOT Act of 2001 requires financial institutions (including broker-dealers) to obtain, verify and record information that identifies each person opening an account (see FINRA, Customer Identification Notice).
The PATRIOT Act requires financial institutions to establish to establish Anti-Money Laundering Programs (“AML Program Rule”) and to have a Customer Identification Program (“CIP”), implemented by 31 C.F.R. § 103.121. The CIP regulation provides that a financial institution may rely on another financial institution subject to the Act, see 31 C.F.R. § 103.121(b)(6), but registered investment advisers are not a financial institution subject to the AML Program Rule requirements of the PATRIOT Act (rules were proposed, but withdrawn by FinCEN). The No-Action Letter issued in 2004 first provided no-action relief allowing a broker-dealer to rely upon a registered investment adviser (“RIA”) to perform some or all of its CIP obligations by treating the RIA as if were subject to the AML Program Rule, which was subsequently and modified in 2005, 2006, 2008 and 2010.
The No-Action Letter issued on January 11, 2011 (“2011 No-Action Letter”) further modifies the requirements for no-action relief by requiring that broker-dealers to undertake appropriate due diligence of the registered investment adviser (RIA) and enter into an agreement with specific performance and production obligations.
Conditions Required in Order to Rely on the 2011 No-Action Letter
In the 2011 No-Action Letter, the Division of Trading and Markets will not recommend enforcement under Rule 17a-8 under the Securities Exchange Act of 1934 if a broker-dealer treats an investment adviser as if were subject to an AML Program Rule for purposes of 31 C.F.R. § 103.121(b)(6) provided that other provisions of the CIP Rule are met, and:
- the broker-dealer’s reliance on the investment adviser is reasonable under the circumstances (discussed below)
- the investment adviser is a U.S. investment adviser registered with the SEC under the Investment Advisers Act of 1940; and
- the investment adviser enters into a contract with the broker-dealer in with specific performance and production obligations (discussed below)
Agreement with the Registered Investment Adviser
The broker-dealer must enter into a contract with the registered investment in which the investment adviser agrees that:
- it has implemented its own AML Program consistent with the requirements of 31 U.S.C. 5318(h) and will update such AML Program as necessary to implement changes in applicable laws and guidance;
- it (or its agent) will perform the specified requirements of the broker-dealers CIP in a manner consistent with Section 326 of the PATRIOT Act;
- it will promptly disclose to the broker-dealer potentially suspicious or unusual activity detected as part of the CIP being performed on the broker-dealer’s behalf in order to enable the broker-dealer to file a Suspicious Activity Report, as appropriate based on the broker-dealer’s judgment;
- it will certify annually to the broker-dealer that the representations in the reliance agreement remain accurate and that it is in compliance with such representations; and
- it will promptly provide its books and records relating to its performance of CIP to the SEC, to an SRO that has jurisdiction over the broker-dealer, or to authorized law enforcement agencies, either directly or through the broker-dealer, at the request of (i) the broker-dealer, (ii) the SEC, (iii) an SRO that has jurisdiction over the broker-dealer or (iv) an authorized law enforcement agency.
The 2011 No-Action Letter specifically lists whom the RIA must provide its books and records on direct request (as opposed to a request of the broker-dealer), which includes the self-regulatory agency with jurisdiction over the broker-dealers, such as FINRA.
Due Diligence Requirements
Of importance, the 2011 No-Action Letter requires that the reliance of the broker-dealer on the registered investment adviser (RIA) must be reasonable. To establish reasonableness of the reliance, a broker-dealers must undertake “appropriate due diligence on the investment adviser…commensurate with the broker-dealer’s assessment of the anti-money laundering risk presented by the investment adviser and the investment adviser’s customer base.” The due diligence must be undertaken at both “the outset” of the relationship with the RIA and “updated during the course of the relationship, as appropriate.”
In particular, prior to any reliance on the RIA, broker-dealers must assess the AML risks of the investment adviser and its customer base and must update the due diligence during relationship, depending on such risks and circumstances arising subsequent to establishment of the relationship. Therefore, broker-dealers will need to establish procedures to address how they will conduct the requisite due diligence, and in particular the AML risks associated with both the investment adviser and its customer base, and the extent and timing of ongoing due diligence depending on such risks.
In addition, a broker-dealer may choose to not rely on the no-action relief of the 2011 No-Action Letter while still contractually delegating the implementation and operation of its CIP to a registered investment adviser, but the broker-dealer will remain solely responsible for assuring compliance with the CIP Rule; thus, a broker-dealer must actively monitor the operation of its CIP and assess its effectiveness.
Broker-dealers relying on the 2011 No-Action Letter should adopt reasonable procedures to address their due diligence requirements and review any existing agreements to verify such agreements contain appropriate performance and production obligations on the registered investment adviser. For additional assistance regarding due diligence procedures or drafting effective agreements with registered investment advisers, please contact Evans & Kob PC at firstname.lastname@example.org.
FINRA issued a proposed amendment to Rule 5122 requiring disclosure in the offering document of the intended use of offering proceeds, expenses, and the amount of selling compensation to be paid to he broker-dealer and its associated persons, in any private placement in which a participating broker-dealer (or its control entity) is the issuer. In addition, the rule requires: at least 85 percent of the offering proceeds must be used for the business purposes identified in the offering document and each offering document to be submitted to FINRA to allow the staff to conduct ex post reviews to assess compliance with the rule and to identify problematic terms and conditions.
Further, the proposed amendments expand Rule 5122 to reach all private placements in which a member firm participates—not just those in which the member firm (or its control entity) is the issuer—while retaining nearly all of the existing exemptions, including those for offerings sold solely to certain institutions, qualified purchasers and other sophisticated investors. However, to reflect the broader scope of the proposed rule and its prior experience with Rule 5122, FINRA proposes to eliminate the exemption for offerings in which a member acts primarily in a wholesaling capacity.
Comment Period Expires: March 14, 2011
To see the full text of Notice 11-04 and proposed amendments, please follow this link to FINRA’s website.
Please contact California-based Evans & Kob PC regarding any of your securities or regulatory questions at email@example.com.
On December 28, 2010, the Securities and Exchange Commission issued Release No. IA-3129, which among other things extended the compliance date for Part 2B of the Form ADV, the brochure supplement and rules related to delivery of the supplement for registered investment advisers under the Investment Advisers Act of 1940.
Previously, the SEC adopted amendments to the Investment Advisers Act of 1940 to require registered investment advisers to provide clients with a brochure and brochure supplements written in plain English. The brochure contains information about the advisory firm, while the supplement contains information about the advisory personnel. Without the extension discussed below, most existing advisers would be required to deliver brochure supplements to new and prospective clients no later than March 31, 2011 and to existing clients no later than May 31, 2011. The extension only applies to the following:
Existing Registered Investment Advisers
Investment Advisers registered with the SEC as of December 31, 2010, and having a fiscal year ending on December 31, 2010 through April 30, 2011, now have until July 31, 2011 to begin delivering brochure supplements to new and prospective clients and until September 30, 2011 to deliver supplements to existing clients. The dates remain unchanged for those with fiscal years ending after April 30, 2011.
Newly-registered Investment Advisers
Advisers filing applications for registration from January 1, 2011 through April 30, 2011, have until May 1, 2011 to begin delivering brochure supplements to new and prospective clients and until July 1, 2011 to deliver supplements to existing clients. The dates remain unchanged for those filing applications for registration after April 30, 2011.
California Department of Corporations – Securities Regulation Division
The Securities Regulation Division of the California Department of Corporations also is extending the deadline to be consistent with the SEC.
Please contact our firm if you need assistance completing your brochure supplement, Form ADV, responding any regulatory issue, modifying your policies and procedures, assessing your compliance risks, ror any other regulatory or arbitration related legal advice at firstname.lastname@example.org.