- FINRA's second annual report on examination findings highlights selected observations identified during supervisory examinations completed during 2018 in the following areas: suitability for retail customers, fixed income mark-up disclosure, reasonable diligence for private placements, and “abuse of authority.”
- FINRA selected the highlighted observations “because of their potential significance, frequency, and impact on investors and the markets.”
- FINRA suggests firms may use this report as a resource to improve their compliance practices and processes based on the experiences of other firms and to better anticipate and address potential areas of concern.
FINRA published its 2018 Examination Report outlining its examination findings, including selected observations that FINRA considers to have “potential significance, frequency, and impact on investors and the markets.” Key observations and characterizations in each of the highlighted areas are outlined below.
Suitability for retail customers: FINRA states that it continues to observe "unsuitable" recommendations to retail investors as well as deficiencies in some supervisory systems for registered representative activities. Key issues reported relate to:
- A lack of procedures or systems to prevent overconcentration in customer accounts, including overconcentration in complex structured notes or sector-specific investments and illiquid securities.
- Inadequate supervision to prevent excessive trading in customer accounts.
- Inadequate supervisory systems and written supervisory procedures to ensure suitability in representatives’ recommendations of variable annuities.
Separately, FINRA conducted a targeted examination on volatility-linked products that focused on the suitability of recommendations to retail customers and the adequacy of firms' supervisory systems and controls related to these products. FINRA reports these targeted examinations highlighted:
- Unsuitable recommendations to retail customers who did not understand the products’ unique risks despite risk disclosures and explicit warnings, and recommendations that were inconsistent with the investors’ investment profile.
- Inadequate due diligence on the unique characteristics, risks, and operational features of these products.
- Insufficient systems and controls to enforce the limited conditions under which sales were permitted.
Fixed income mark-up disclosure: FINRA observed that some firms faced challenges when implementing amendments to FINRA Rule 2232 (Customer Confirmations) and MSRB Rule G-15 that required firms to provide additional transaction-related information to retail customers, including the mark-up or mark-down for principal trades. These challenges ranged from failure to enter information into order entry systems, improper adjustments to prevailing market prices, inadequate disclosures, and vendor issues.
Reasonable diligence for private placements: FINRA summarizes that examiners observed instances where some firms that have suitability obligations under FINRA Rule 2111 (Suitability) failed to conduct reasonable diligence on private placements and failed to meet their supervisory requirements under FINRA Rule 3110 (Supervision), including:
- Failure to investigate red flags identified during the reasonable diligence process.
- Overreliance on third-party conclusions and reports.
- Use of third-party due diligence reports that issuers paid for or provided in their due diligence analysis without considering the related conflicts of interests.
Abuse of authority: Customers give registered representatives authority to act on their behalf when they provide authorization to engage in discretionary trading or permit registered representatives to act as trustees, hold Powers of Attorney or serve as executors or beneficiaries. FINRA reports that examiners observed situations where some firms or registered representatives exposed investors to unnecessary risks (such as unsuitable investments or excessive trading) and had not established controls to mitigate those risks. These situations included:
- Trades in customer accounts without proper authorization or after authorization had expired.
- Mismarked order tickets to obscure unauthorized discretionary trading.
- False statements on the firm's compliance questionnaires and attestations regarding discretionary authorization, or customers signed blank suitability or new account forms.
- Efforts to convince senior investors to establish trusts and name the representatives as trustees or co-trustees in order to take control of the trust assets and direct funds to themselves.
The report also outlined additional observations in the following areas (some of which were identified in FINRA's 2017 Examination Report).
- Anti-money laundering (AML) including the adequacy of AML programs, allocation of monitoring responsibilities, and data integrity in monitoring surveillance systems.
- Accuracy of net capital computations, including consistency with the Net Capital Rule and related guidance from SEC staff.
- Liquidity, where FINRA suggests some firms may benefit from expanding the breadth and scope of their stress testing.
- Segregation of client assets, where firms face challenges complying with rules designed to protect customer funds and securities.
- Operations professional registration, including instances where unregistered staff are permitted to engage in certain activities that would require status as a registered Operations Professional.
- Customer confirmations, including inaccurate disclosures and inadequate supervisions.
- DBAs and communications with the public, including failure to disclose the firm’s name and failure to hyperlink to FINRA’s BrokerCheck.
- Best execution, including failure to comply with FINRA Rule 5310 (Best Execution and Interpositioning) and reliance upon a deficient “regular and rigorous review” of customer order execution quality.
- TRACE reporting, including an overreliance on FINRA’s list of TRACE-eligible securities, late or inaccurate reporting, and inaccurate indicators and/or identifiers.
- Market access controls, including challenges with intra-day adjustment of pre-trade financial thresholds and oversight of third-party vendors.
FINRA suggests firms can use this report as a resource to improve their compliance practices and processes based on the experiences of other firms and better anticipate and address potential areas of concern.