We are pleased to share with everyone Josh Horn’s excellent guidance on RIA conflicts of interest, recently, published in the Practical Compliance and Risk Management for the Securities Industry, a professional journal published by Wolters Kluwer Financial Services, Inc. See PCRM_01-15_Horn-Shah-C3.
FINRA recently censured and fined a broker-dealer $175,000.00 for failing to perform appropriate due diligence and supervision regarding private placements that the firm and its registered representatives offered. This penalty should serve as a wake-up call that FINRA is taking a sharp look at the due diligence that firms perform before and after offering a private placement to its clients.
The firm had a number of missteps regarding a handful of private placements that FINRA discovered during a routine examination, which included the following:
- The firm approved an offering even though the firm highlighted shortcomings in the offering such as a failure to describe the company’s business; FINRA found the firm providing additional disclosures did not satisfy Rule 2111.
- The firm distributed a private placement memorandum to potential investors even though it did not include certain material facts and relied on flawed methodology for projecting ROI.
- The firm sold an offering in which one of its associated persons was affiliated without adequate supervision of that person.
- The firm failed to confirm that certain offering documents were filed with FINRA.
- Another associated person participated in an offering away from the company without supervision.
- The firm allowed associated persons to send consolidated reports to its customers, but failed to adequately supervise these reports.
This conduct implicates a number of FINRA Rules (i.e., 2010, 3010, 3040 and 5122), and demonstrates that FINRA is looking at many different kinds of conduct when it comes to private placements. Although these types of investments offer firms diverse investment options for their clients, firms must take a step back before taking three forward.
FINRA’s sanction highlights that firms must fully review offerings before approving them and then properly supervise the sale of the offerings and those persons selling the offerings. Otherwise, you will likely get stung for not doing so in your next examination.
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FINRA is planning on turning up the heat on perceived “high-risk” brokers this year, and the firms that hire them. Continuing our discussion regarding FINRA’s 2015 Regulatory and Examinations Priorities Letter, this blog entry will discuss FINRA’s planned activities to prevent and/or stop registered representatives from engaging in actual misconduct.
In an effort to protect the investing public from potential fraud, FINRA is planning to take extra steps this year to identify and remove “unscrupulous registered representatives who prey on investors”. To achieve this, FINRA promises to expand its use of data mining, analytics, and specially targeted examinations, in addition to increasing their use of expedited investigations and enforcement actions.
FINRA is also focused on firms that seek to hire high-risk brokers, including “statutorily disqualified and recidivist brokers”. FINRA plans to review firms’ due diligence on prospective brokers during the hiring process. FINRA also is focused on firms’ supervision of high-risk brokers, including whether the firm implements and follows a stated supervisory plan.
Firms should expect increased scrutiny this year as FINRA tries harder than ever to identify high-risk brokers and prevent misconduct. Per FINRA’s suggestions, firms should consider updating and/or creating (if one does not already exist) a plan regarding the hiring and supervision of potentially high-risk brokers, so as to meet FINRA’s expectations during an examination.
FINRA’s 2015 Regulatory and Examinations Priorities Letter provides guidance regarding areas of focus in the “Sales Practice” for this year. Previously, we discussed the various sales products that FINRA will be monitoring this year; and yesterday, Josh Horn discussed FINRA’s recently adopted Supervision Rules that affect the Sales Practice. This blog entry will discuss FINRA’s focus on firms’ controls regarding “Wealth Events”, particularly Individual Retirement Account (IRA) Rollovers.
FINRA is concerned with the long term impact of brokers’ recommendations when approached by an investor that is faced with a decision about what to do with a large amount of money arising from an inheritance, life insurance payout, sale of a business or other major asset, divorce settlement, or an IRA rollover, among other “Wealth Events”. FINRA plans to closely monitor firms’ controls for compliance, supervision, suitability, and disclosures regarding these “Wealth Events” in 2015.
As more than 25% of Americans are investing their retirement savings in IRAs, FINRA plans to specifically focus on firms’ controls in this area. In particular, FINRA appears concerned with firms’ marketing their own broker-dealer sponsored IRAs. FINRA will closely monitor communications and firm policies, focusing on practices regarding the disclosure of fees and costs related to the IRAs.
Firms and broker-dealers that provide investment advice regarding Wealth Events, particularly IRAs, should take extra steps to ensure they are FINRA compliant this year. FINRA has explicitly targeted this area for additional oversight in 2015. Thus, firms should conform their policies, procedures, controls, disclosures, and training to meet FINRA’s expectations.
FINRA noted in its exam priorities that it will be focusing on firms’ compliance with the new supervision rules (FINRA Rules 3110, 3120, 3150 and 3170). These rules became effective on December 1, 2014.
Now that two months have passed since their effective date, firms should have taken the changes into account in their written supervisory procedures and in practice. These new rules modified existing requirements regarding the following:
- Supervising offices of supervisory jurisdiction and inspecting non-branch offices.
- Managing conflicts of interest through the supervisory system.
- Risk-based review of correspondence and internal communications.
- Risk-based review of investments banking and securities transactions.
- Monitoring for insider trading, conducting internal investigations, and reporting the results to FINRA.
- Testing and verifying supervisory control systems.
By highlighting these changes in its 2015 exam priorities, FINRA has teed these issues up for member firms. Indeed, FINRA has made it known that it will be looking at how firms have implemented the change to the rules on supervision.
Before your next examination, ask whether your firm has taken these changes into account. If not, the best course of action is to develop and implement a supervisory system that takes these changes into mistake. Otherwise, you will likely face issues at the conclusion of your exam.
*photo from freedigitalphotos.net
The SEC and FINRA have continued to designate cybersecurity as an exam priority. Both the SEC and FINRA have also recently published the findings of their exam sweeps. As reported by the Investment News, the results of those sweeps when it comes to cybersecurity are telling.
The sweeps show that firms, much like with compliance, are not but must set the tone at the top when it comes to data security. In order to have a successful cybersecurity programs, data security has to be a firm-wide concern, not just a creature of the IT department.
Of additional interest are the differences between brokers and investment advisors. Although the majority of all firms have written policies on cybersecurity, more brokers than investment advisors audit those policies to determine firm compliance, which raises a fundamental issue. A policy is only as good as those who stand behind it and ensure compliance with it.
Firms should expect little sympathy from their regulators if they think that only having a written policy on cybersecurity is enough. Undoubtedly, the SEC and FINRA will want to know what you have done to ensure compliance with those policies.
So what should firms do to avoid this impending wrath? First, make sure you have robust written policies that address cybersecurity from a firm-wide standpoint. Second, deploy the resources necessary to ensure that you are executing on those policies.
Although no data security program is perfect, make sure you have one and enforce it. Protect your clients. Protect your firm. And avoid regulatory sanctions in the process.
* photo from freedigitalphotos.net
If you are not asking that question, FINRA may as its recent $350,000 fine levied against a major brokerage house indicates. In that instance, FINRA found that the brokerage charged 20,000 customers a total of $2.4 million too much for certain transaction fees.
For its part, the SEC is going after private equity firms because it has found in its examinations that there has been a high rate of deficiency on fee collection and expense allocation.
Even greater focus is being directed to firms that are dual registrants because those firms can move clients from fee-based to commission-based accounts. The conduct they are focusing on is called reverse churning. Reverse churning happens where a client pays a fee for assets under management, but then barely executes any trades, which would otherwise warrant the use of a fee-based account.
Whatever fee system your firm uses, make sure that you take the time to make sure that it fits your clients. If the client executes many trades, should the client be in a fee-based account. Conversely, for those clients who do not execute many trades a year, do you have that one in a commission-based account.
Each account should be examined when it is opened and at least once a year to make sure that it is in the proper account from a fee standpoint. Ask these questions now, and avoid your regulator answering them for you.
* Photo by freedigitalphotos.net
Earlier this month, FINRA released its 2015 Regulatory and Examinations Priorities Letter. In the letter, FINRA lays out its 2015 priorities, which focus on three general areas: 1) Sales Practice; 2) Financial and Operational Priorities; and 3) Market Integrity. This blog entry will discuss FINRA’s “Sales Practice” priority.
FINRA is focused on various sales products for the upcoming year. FINRA promises to regularly review product-related risks and examine firms’ and registered representatives’ due diligence, suitability, disclosure, supervision, and training related to those products. The specific products mentioned by FINRA include:
- Interest Rate-Sensitive Fixed Income Securities – FINRA examiners plan to test for suitability and adequate disclosures, as well as review firms’ efforts to educate registered representatives and customers about these products.
- Variable Annuities – In addition to focusing on the sale and marketing of these products, particularly with regard to “L share” annuities, FINRA will focus on compliance training and procedures related to variable annuities.
- Alternative Mutual Funds – One of FINRA’s primary areas of focus regarding these products is ensuring accuracy in product descriptions, especially in the funds’ prospectus.
- Non-Traded Real Estate Investment Trusts (REITs) – FINRA emphasized the changes of Regulatory Notice 15-02, which is not effective until next year, but will require more accurate per share estimated value on customer account statements, as well as various important disclosures regarding REITs.
- Exchange-Traded Products (ETPs) Tracking Alternatively Weighted Indices – FINRA plans to monitor the indices and products tracking them will behave in different market environments.
- Structured Retail Products (SRPs) – FINRA will focus on policies and procedures regarding sales incentives for these products, as well as conflicts of interest that may arise where the distributor and wholesaler are affiliated.
- Floating-Rate Bank Loan Funds – FINRA warns of potential liquidity challenges for investors in these loans.
- Securities-Backed Lines of Credit (SBLOCs) – FINRA wants companies to have proper monitoring and controls in place with regard to these products, ensuring that customers are kept informed of the products’ features.
If your firm deals in any of these sales products, you can bet that FINRA will have its eye on your firm this upcoming year. Companies and in-house counsel should be prepared for increased FINRA oversight and scrutiny in these areas. Thus, it is critical to get ahead of any possible FINRA examinations or investigations by ensuring that you are fully complying with FINRA’s recommendations regarding these products.
It is that time of year again. The SEC Office of Compliance and Inspection (OCIE) has announced its examination priorities for 2015. Knowing what these priorities are will help firms gauge their compliance and supervision efforts over the next year.
For firms that are in the retail sector, OCIE has identified particular areas of interest. These areas include the following: OCIE will focus on firm recommendations when there is a variety of fee arrangements and account structures at the firm.
- OCIE is focusing on whether the arrangements and the fees charged are in the best interest of the client.
- OCIE is looking into the use of improper or misleading sales practices when recommending the movement of retirement assets from employee-sponsored defined contribution plans into other investments, especially those with higher fees.
- OCIE is looking into the suitability of investing retirement assets into complex or structured products, including due diligence, and disclosures made to the investor.
- OCIE is looking into the supervision of branch offices, including using data analytics to identify branch offices that may be deviating from firm compliance.
- OCIE is continuing its focus on investment companies that are offering alternative investments.
- OCIE is looking into whether mutual funds with significant exposure to interest rates increases have implemented compliance policies, procedures and sufficient controls to ensure its disclosures are not misleading and that the investment profile is consistent with the disclosures.
Now that you know the SEC’s focus for the year ahead, ask yourself whether your firm is doing what it needs to do to answer the above issues with a positive response. If no such response is forthcoming, you need to revisit what you are doing and act accordingly, lest you be a firm OCIE focuses upon.
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Starting July 1, member firms are required to have written procedures to verify the accuracy and completeness of the information in a registered representative’s U-4 within 30 days of the U-4 being filed with FINRA. The question that arises is whether the expense of this new type of “investigation” is worth it.
In short, member firms will have to do more than a simple internet search of a potential hire, particularly if the firm finds something on the new hire. For example, what do you do if the new hire was sued in the past?
Under this new requirement, it is fair to say that you will have to do more than just look at a docket. Instead, it is likely that, in order to comply, you will have to review documents filed in the case to see if there were allegations against the new hire such as for fraud or other things that would present cause for concern.
This heightened analysis will certainly take time and money to complete. If you are hiring a big producer, then the analysis is probably only a minor inconvenience, but what about if the new hire is not a big producer? How much is enough?
Undoubtedly, firms will likely need to have bright line tests for when they will keep reviewing, as opposed to declining to hire a person with a complicated past. There will certainly be a market for other firms to conduct this analysis for you. Either way, member firms have to do more than a passing glance at a new hire’s U-4.
There is likely going to be a fair amount of question regarding how much is enough of a review. Nevertheless, get your written procedures in place and have a game plan for how you will review the veracity of a new hire’s U-4. Otherwise, you face the risk of suit for negligent hiring and the wrath of your regulator.
* Photo by freedigitalphotos.net