Brokerages face tougher recidivist scrutiny and remote exams

Broker-dealers can expect to face ramped-up regulatory focus in 2017 on how they handle employees with disciplinary histories – and some will be examined by off-site officials.

These are among the issues highlighted in the Financial Industry Regulatory Authority’s (Finra) latest annual regulatory and examination priorities letter, released last week.

High-risk and recidivist brokers have been a cause of concern for the self-regulatory organization (SRO) for some time; in 2013 it launched an initiative to identify such individuals and expedite investigations. But in this year’s letter Finra officials highlight how they plan to beef up their scrutiny in the area.

For example, Finra will review firms’ supervisory procedures for hiring or retaining statutorily disqualified and recidivist brokers, officials write. It will examine firms’ due diligence on these individuals, including whether, as part of the verification process, a firm or third-party service provider conducts a national search of reasonably available public records to verify the accuracy and completeness of the information contained in an applicant’s Form U4.

The SRO will assess whether firms develop and implement a supervisory plan reasonably tailored to detect and prevent future misconduct by a particular broker based on previous misconduct and regulatory disclosures, according to the letter.

‘We will also focus on firms with a concentration of brokers with significant past disciplinary records or a number of sales practice complaints or arbitrations,’ officials write. ‘At the same time, we will continue to scrutinize closely applications by firms to associate with statutorily disqualified persons and will oppose these plans where we conclude that they do not satisfy applicable requirements.’

Finra recently established a dedicated examination unit to identify and examine brokers that may pose a high risk to investors. In 2017 this group will review these brokers’ interactions with customers, including their compliance with rules regarding suitability, know-your-customer, outside business activities, private securities transactions, commissions and fees.

The SRO will also continue to evaluate firms’ branch office inspection programs and their supervisory systems for branch and non-branch office locations, including independent contractor branches. Finra’s focus for these reviews will include:

• The supervision of account activity
• Advertising and communications, including the potential use of unapproved email addresses for business communications with customers, including through the use of social media
• Registered representatives’ websites
• Outside business activities
• The use of consolidated account statements
• Operational activities such as distribution of funds and changes of address or investment objectives.

ELECTRONIC EXAMS
As usual, many of the themes in the letter have appeared in previous years but some of the items are new. Among the latter, Finra will launch electronic, off-site reviews to supplement its traditional on-site cycle exam, officials write.

‘This program will enable Finra to review selected areas, typically those covered in this letter, without going on site to the firm,’ they note. ‘Instead, Finra will make targeted and limited information requests to firms and then analyze responses off-site. We will conduct these off-site exams only on a select group of firms that are not currently scheduled for a cycle exam in 2017.’

A Finra spokesperson did not have additional details of the program.

Among other new items on the agenda, the SRO this year will review firms’ implementation of obligations established in amendments to Rule 4210 that establish margin requirements for covered agency transactions. The first phase of the new amendments became effective December 15, 2016.

‘We will assess firms’ written risk policies, procedures, risk-limit setting processes and the way firms establish and supervise for compliance with the rule’s requirements,’ officials say in the letter.

The letter also suggests broker-dealers can expect an easier regulatory approach to trading-related compliance problems. At present, Finra’s audit trail-reporting early remediation initiative identifies and alerts firms to potential issues not detected through routine compliance sweeps and reviews. The SRO uses this tactic to give firms the chance to correct systems issues and potentially avoid a formal investigation. This year, officials say, it will expand the initiative to other areas such as Regulation NMS trade-throughs and locked-and-crossed markets.

Robert Frenchman, shareholder with Greenberg Traurig, tells Corporate Secretary that firms would applaud such an approach, not least because they often experience inadvertent issues related to trade-throughs. 

Asked whether it is realistic for the SRO to take such an approach, the Finra spokesperson tells Corporate Secretary: ‘It is a more effective use of both Finra’s and the firms’ resources to troubleshoot and correct these problems through this proactive call-out process, opening formal investigations only when the problem is widespread and long-standing or the firm does not take sufficient steps to address the issues.’

During the first half of 2016, the early remediation initiative resolved 129 issues, spending an average of seven hours on each, compared with an average of 40 or more hours to close a formal investigation, the spokesperson says. Eighty-two percent of the issues resolved during the first half of 2016 were resolved without the necessity of staff opening a formal matter, he adds.


CONCERNS
Finra also uses the letter to highlight compliance problems in the industry to encourage firms to make sure they are up to speed in those areas. In some cases, the SRO has found issues through targeted exams carried out in 2016. For example, the SRO is seeing numerous cases where registered reps have recommended that senior investors purchase speculative or complex products in search of yield.

‘While the quest for higher yield is not per se problematic, Finra will assess whether such recommendations were suitable given an investor’s profile and risk tolerance, and whether firms have appropriate supervisory mechanisms in place to detect and prevent problematic sales practices,’ officials write. Calls to Finra’s helpline for seniors ‘have exposed troubling scenarios of senior and unsophisticated investors buying into sales pitches for speculative energy-based investments,’ they add.

Over the last year, the SRO has also seen these concerns particularly frequently with respect to complex or novel exchange-traded products, structured retail products, leveraged and inverse exchange-traded funds, non-traded real estate investment trusts (Reits) and unlisted business development corporations (BDCs). Finra conducted a sweep exam this past summer looking at the latter two.

‘While these products can be appropriate for some customers, certain non-traded Reits and unlisted BDCs, for example, may have high commissions and fees, be illiquid, have distributions that may include return of principal, have limited operating history or present material credit risk arising from unrated or below investment grade products,’ officials write. ‘Given these concerns, firms should make sure that they perform and supervise customer-specific suitability determinations.’

In addition, Finra draws firms’ attention to areas where officials have spotted repeated shortcomings in regards to cyber-security controls:

• Controls at branch offices, particularly independent contractor branch offices, tend to be weaker than those at firms’ home offices – including poor controls related to the use of passwords, encryption of data, use of portable storage devices, implementation of patches and virus protection
• Firms have failed to fulfill one or more of their obligations under Rule 17a-4(f) that requires them to, among other things, preserve certain records in a non-rewriteable, non-erasable format.