The Financial Industry Regulatory Authority (FINRA) recently published its 2018 Report on FINRA Examination Findings, focusing on (1) suitability for retail customers, (2) fixed income markup disclosure, (3) reasonable diligence for private placements, and (4) abuse of authority. For each highlighted area of focus, FINRA identified examples of misconduct, as well as sound supervisory practices to prevent and/or mitigate that misconduct.
Suitability for Retail Customers
In its report, FINRA observed situations in which registered representatives did not adequately consider investment profile factors, fees, and/or commissions when making recommendations. Those recommendations resulted in overconcentration, excessive trading, and unsuitable variable annuity recommendations.
FINRA noted that firms with sound supervisory practices identified risks, developed policies, and implemented controls tailored to the specific features of the products they offer and the customer bases they serve by (1) restricting recommendations through systematic “hard blocks,” (2) verifying the source of funds for variable annuity transactions, and (3) training supervisors on product risks and performance characteristics for complex products before the registered representatives recommend them.
Fixed Income Markup Disclosure
FINRA observed that firms faced challenges in implementing the changes required by FINRA Rule 2232 and MSRB Rule G-15. Such challenges included (1) failures to enter information into the firms’ order entry systems; (2) improper adjustments to prevailing market price (PMP); (3) inadequate disclosures for trades conducted on an agency basis; (4) failures to provide disclosure for structured notes; (5) incorrect designations of “institutional accounts”; (6) improper security-specific hyperlinks and descriptions; and (7) vendor challenges, such as vendors’ failure to identify the correct PMP to calculate markups and markdowns.
In its findings, FINRA noted that firms should (1) perform regular reviews of confirmations to ensure that its confirmations include the require disclosures, particularly (a) the markup or markdown and (b) the time of execution and the security-specific link to the FINRA or MSRB website (with CUSIP); (2) conduct diligence regarding (a) clearing firms’ processes for providing markup disclosure and (b) vendors’ processes to determine PMP; and (3) ensure that there are consistent and correct disclosures for fixed income transactions executed across different vendors, platforms, and/or trading desks.
Reasonable Diligence for Private Placements
Firms have an obligation to conduct a “reasonable investigation of the issuer and the securities” for private placements. During its examinations, however, FINRA observed that certain firms both failed to conduct reasonable diligence and relied excessively on third parties’ due diligence reports without conducting their own independent analyses.
FINRA also noted that certain firms did perform reasonable diligence by (1) conducting meaningful, independent research on material aspects of the offering; (2) identifying any red flags with the offering or the issuer; and (3) addressing and resolving concerns relevant to potential investors. Firms’ due diligence procedures included the following:
- Creating a committee to determine whether to approve the offering;
- Independently verifying key, performance-related information;
- In offerings involving issuers that were affiliates of the firm or whose control persons were also employed by the firm, mitigating conflicts of interest, ensuring suitability in spite of such conflicts and developing comprehensive disclosures;
- Establishing post-approval processes and investment limits based on the complexity or risk level of the offering; and
- After the offering, conducting ongoing diligence to ensure proceeds were used in a manner consistent with the offering memorandum.
Abuse of Authority
FINRA Rule 2510 provides that registered representatives may engage in discretionary trading in executing a securities transaction only after receiving prior written authorization from the customer. During its examinations, FINRA observed situations in which registered representatives exposed investors to unnecessary risks and firms failed to comply with Rule 2510. Specifically, registered representatives (1) exercised discretion without receiving authorization from the customer or after the authorization expired, (2) mismarked order tickets and/or made false statements to obscure unauthorized discretionary trading, and (3) abused their status as trustees to direct senior investors’ assets to themselves.
FINRA stated that firms employing robust supervision programs implemented automated systems to detect potential excessive trading in customer accounts, inconsistencies or errors related to the completion of customer new account forms, and indications of customers granting discretionary authority to their registered representatives. Those firms also trained their registered representatives on the requirements of NASD Rule 2510 and required them to complete periodic attestations indicating whether they maintained any discretionary accounts or otherwise exercised discretion. Further, FINRA observed that certain firms restricted and/or prohibited their registered representatives from acting in some positions of trust (e.g., trustees, powers of attorney, executors) and/or mitigated potential conflicts of interest involved in such roles by implementing additional supervisory procedures (e.g., periodically asking customers to complete questionnaires to confirm their authorization for registered representatives to exercise discretion).
FINRA also discussed additional observations related to (1) Anti-Money Laundering, (2) Accuracy of Net Capital Computations, (3) Liquidity, (4) Segregation of Client Assets, (5) Operations Professional Registration, (6) Customer Confirmations, (7) DBAs and Communications with the Public, (8) Best Execution, (9) TRACE Reporting, and (10) Market Access Controls.
The full 2018 Report on FINRA Examination Findings is available on FINRA’s website.