The enforcement mission of the Financial Industry Regulatory Authority is, by design, a public one. Not only does it publicize the filing, settlement and adjudication of cases it brings against regulated persons and entities, it also regularly communicates with its membership and the public regarding its goals. As such, there are two basic sources of information about examination and enforcement priorities. The first source is FINRA’s annual examination priorities letter. The second source is the information FINRA makes public about its disciplinary actions.
The Priorities: The Examinations Priorities Letter
On Jan. 11, 2013, FINRA published its examination priorities letter for the coming year. This year’s letter is significantly more focused and shorter than prior letters. The letter identifies 18 areas that will be the focus of FINRA’s examinations and enforcement efforts, grouped into four major categories, each of which is discussed below. Amid the tried and true general areas of attention such as retail investor suitability, which is perennially on its list FINRA has added some very specific priorities, such as the use of “kill switches,” as a failsafe against extreme trading events, which are more pointed than any prior guidance.
The letter’s first category of priorities comes under the heading “Business Conduct and Sales Practice Priorities.” Continuing a theme from prior years, the letter cautions that “retail investors have been challenged to find attractive returns within their risk tolerance.” With this and other concerns in mind, FINRA will be looking at suitability, sales of complex products, microcap fraud, private placement securities, anti-money laundering, automated investment advice and branch office supervision, among other issues. As in prior years, FINRA has said it will focus on protecting retail investors. Of special note is FINRA’s interest in cybersecurity and data integrity, a priority that FINRA is likely to explore through examination of firms’ policies, procedures and controls surrounding the protection of sensitive customer information from breaches, unauthorized access and other disruptions.
Each year, certain products and investments are identified as the subject of FINRA’s scrutiny. This year, business development companies, leveraged loan products, commercial mortgage-backed securities, high-yield debt instruments, structured products, exchange-traded funds and notes, nontraded REITS, closed-end funds, municipal securities, variable annuities, low-priced OTC securities and private placement securities were specifically mentioned.
“Insider Trading” is the second broad category listed, replacing “Microcap Fraud,” which was the second priority on the 2012 letter (although it lives on as an item of interest in the Sales Practice category). FINRA emphasized the need for firms to be “vigilant” in protecting material nonpublic information, suggesting six specific controls, in the form of reviews, training, and policies and procedures, that firms should assess for adequacy. While none of these controls is novel, the thrust of FINRA’s objective will be aimed at ensuring that the controls are fully implemented and followed by employees.
“Financial and Operational Priorities” is the third category and includes a detailed reiteration of the requirement that firms follow GAAP in appropriately valuing and accounting for guarantees and contingencies, with an eye toward net capital requirements. The letter also discusses concerns in the area of margin lending and, in light of historically low interest rates, the potential of mismatches between the maturities of a firm’s assets and liabilities.
“Market Regulation Priorities” rounds out the major categories discussed in the letter. In this category, some of the priorities such as FINRA’s concerns about automated investment advice, alternative trading systems and large options position reporting are new priorities. In light of the market’s vulnerability to disruption, FINRA will “focus significant resources” on algorithmic trading, high-frequency trading abuses, alternative trading systems and options origin codes.
At an October 2012 SEC Roundtable on Market Technology, academic and industry panelists vigorously discussed the concept of exchange “kill switches” as a response to recent market disruptions. The 2013 letter declares that FINRA will “focus on whether broker-dealers have firmwide disconnect or ‘kill’ switches, as well as procedures for responding to widespread system malfunctions.” Presumably FINRA’s requirement that firm’s have a kill switch is derived from the SEC’s Market Access Rule, 15c3-5, rendered subject to FINRA’s enforcement authority through FINRA Rule 2010.
While some priorities from prior years are not mentioned in the 2013 letter, no one should assume that FINRA staff will not vigorously pursue such staples of FINRA enforcement such as information barriers, email retention and review (beyond the specific references as part of insider trading controls), OATS and advertising. Just as supervision plays a part in a large portion of FINRA’s disciplinary actions, FINRA’s emphasis on reviewing member firm supervision is woven throughout the letter.
The Results: FINRA’s Disciplinary Actions Against Firms and Associated Persons
In 2012, FINRA brought 1,541 disciplinary actions, levied $68 million in fines and ordered $34 million in restitution. While FINRA reports the total number of cases resolved each year, it does not provide a breakdown of actions by subject area. FINRA does publish a monthly summary of disciplinary actions that meet the publication criteria established in FINRA Rule 8313. For a small subset of more prominent cases, FINRA also publishes a press release. Since 2009 the number of firms named in press releases about disciplinary actions has fluctuated between 30 and 40 per year. The current practice appears to be to issue a press release only for actions with fines or restitution of $300,000 or more.
FINRA’s “Disciplinary Actions” webpage generally does not cite the section of law, federal securities regulation, or FINRA rule violated. Thus, it is impossible to derive a precise breakdown of the rules being enforced in FINRA disciplinary actions from the 709 pages of published disciplinary actions for 2012. Now that FINRA makes all disciplinary actions searchable through its Disciplinary Actions Online Database it is possible — though not easy — to obtain greater insight into the results of FINRA’s disciplinary actions.
In 2012, FINRA published descriptions of 401 disciplinary actions against 312 different FINRA member firms. Sixty firms were the subject of multiple disciplinary actions. Among actions against firms in 197 instances, or 49 percent, there was a finding of some form of supervisory violation. Many actions against firms included more than one nonsupervisory violation. FINRA brought approximately 1,140 actions against individuals associated with member firms, barring 294 individuals and suspending 549.
The 25 press releases about disciplinary actions in 2012 were strongly focused on cases with customer harm. The most common violations, other than supervision, described in the press releases were fraud, pricing and markups.
There is some overlap in the following breakdown of nonsupervisory violations as many cases involve a finding of more than one rule violation.
Cases against firms involving customer harm from fraud, deceptive sales practices, suitability and pricing (e.g., markups, excessive compensation and best execution) accounted for approximately 24 percent of the violations. Cases involving customer harm usually result in stiff sanctions and generally represent a significant allocation of FINRA’s enforcement resources. FINRA also brought numerous cases for failure to supervise the conduct of associated persons which could, or did, lead to customer harm.
FINRA actions against firms involving some form of reporting or disclosure requirement (OATS, TRACE, RTRS, equity reporting, short-interest reporting, U-4/U-5 disclosure, customer complaints, etc.) represented 40 percent of the nonsupervisory violations for which sanctions were imposed by FINRA.
Other areas not involving direct customer harm or risk (e.g., email retention, books and records, AML reporting and improper responses to FINRA inquiries) accounted for another 14 percent of violations. Failure to comply with prophylactic regulations designed to protect investors (e.g., registration requirements, net capital and reserves, and short sale restrictions) were involved in approximately 13 percent of the findings.
FINRA’s statement of examination priorities adds transparency to FINRA’s examination and disciplinary process and is a helpful tool to promote compliance through education. Firms will also gain insight into FINRA’s priorities by examining the cases brought last year as they tend to be an excellent predictor of types of cases that will be brought in the next year.
This article originally appeared in the January 31, 2013 edition of Law360 (www.law360.com) and is reprinted with permission.
Richard G. Wallace
Joseph D. Edmondson, Jr.