SEC and FINRA 2016 Exam Priorities

January 22, 2016

The SEC and FINRA have recently released their exam priorities for 2016. As a preview, both regulators continue to focus on cybersecurity, sales to senior investors, and microcap securities and the associated risks of “pump-and-dump” schemes. Below you will find a summary of the regulators’ current priorities.

SEC 2016 examination priorities

In 2016, the SEC will focus on retail investor issues (including those saving for retirement), market-wide risks and identifying registrants that may be engaged in illegal activity.

1. Protecting retail investors.

The SEC will continue to focus on assessing risks to retail investors by examining broker-dealers and RIAs that provide services to customers whose investment goals revolve around retirement. The SEC’s retail investor initiatives include:

  • ReTIRE: This is a multi-year initiative that focuses on the areas of suitability, conflicts of interest, supervision and disclosures as they relate to retirement accounts.
  • ETFs and annuities: The SEC will focus on sale strategies, disclosures and suitability relating to exchange-traded funds and variable annuities.
  • Account types: The SEC will review recommendations regarding account type to ensure that retail customers are being placed into accounts with appropriate fees (asset-based fees, hourly fees, wrap fees, commissions, etc.).
  • Public pension advisers: The SEC will continue to examine advisers that work with municipalities and other government agencies and focus on pay-to-play issues such as undisclosed gifts and entertainment.

2. Assessing market-wide risks.

The SEC has prioritized examining structural risks and trends in the market, including a continued focus on cybersecurity. In 2016, the SEC will test firms’ procedures and controls that have been implemented in conjunction with its September 2015 Cybersecurity Examinations Initiative. The scope of this initiative was broad and included managing risks associated with firm systems and third-party vendors that have access to customer data, and firms’ procedures and plans to respond to security breaches.

Other market risk priorities include: (1) working with other regulators to identify risks associated with clearing firms; (2) examining the liquidity controls of mutual funds, ETFs and private funds; and (3) testing the systems and data back-up centers of Systems Compliance and Integrity entities, which includes registered clearing agencies, alternative trading systems, plan processors and exempt clearing agencies.

3. Identifying potential illegal activity using data analytics.

The SEC will continue to use its experience and data access to identify firms and representatives it believes have an elevated risk profile. The SEC has identified the following areas of high risk:

  • Individuals with a history of misconduct; 
  • A volume of Suspicious Activity Reports (SARs) that is less than what should have been filed based on a firm’s business model and size, 
  • Late or incomplete SARs;
  • Firms that are aiding in pump-and-dump schemes or market manipulation of microcap investments;
  • Excessive trading; and
  • Product promotion of complex or high-risk products.

4. The SEC’s other areas of focus in 2016.

In addition to the three above categories for 2016 exam priorities, the SEC will also allocate resources to examine issues relating to municipal advisors, private placements, fees charged by private fund advisers, transfer agents and RIAs that have not previously been examined.

The complete SEC release, dated January 11, 2016, regarding its 2016 exam priorities may be accessed here:

FINRA 2016 examination priorities

For 2016, FINRA will focus its exam priorities on firm culture, conflicts of interest and ethics, risk management and controls, and liquidity issues.

1. Culture, conflicts of interest, and ethics.

FINRA has identified five cultural indicators it will consider in determining how a firm’s culture influences compliance and risk management practices. These cultural indicators are whether: (1) a firm’s control functions are valued within the organization; (2) a firm tolerates policy or control breaches; (3) the firm proactively seeks to identify risk and compliance events; (4) a firm’s supervisors are effective role models of firm culture; and (5) non-conforming subcultures within a firm are identified and addressed.

2. Supervision, risk management and controls.

FINRA will focus on four areas of supervision and risk management that it considers important for the integrity of the market: Management of conflicts of interest, technology, outsourcing and anti-money laundering (AML).

  • Managing conflicts: FINRA will focus on firms’ incentive structures and the manner in which they mitigate conflicts of interests in connection with the sale of proprietary products or receiving third-party payments such as revenue sharing.
  • Technology: Like the SEC, FINRA will continue to focus on cybersecurity but will also focus on the firms’ ability to comply with Regulation S-P and the record retention requirements in Rule 17a-4(f). FINRA’s focus is broad, and will cover hardware, software and personnel issues. Specific areas on which FINRA will focus on include: governance, risk assessment, technical controls, incident response, vendor management, data loss prevention and staff training.
  • Outsourcing: FINRA’s priority letter reminds firms that they must supervise third-party service providers and not outsource functions only qualified registered persons must perform. In 2016, FINRA will be reviewing how firms conduct due diligence when they select such third parties, what ongoing due diligence is performed and what efforts firms take to supervise them.
  • AML: Similar to the SEC, in 2016, FINRA will examine firms to ensure they are monitoring high-risk customer accounts and transactions, especially those involving microcap securities. This will focus on examining firms’ monitoring for suspicious activities from both a money movement and trade activity perspective. With respect to microcap securities, FINRA states firms should consider their processes to ensure compliance with registration requirements when individuals deposit large blocks of microcap securities (traded on the pink sheets and OTC Bulletin Board). For example, Securities Exchange Act Rule 15c2-11 and FINRA Rule 6432 identify information that should be collected and maintained by broker dealers prior to publishing quotes for unlisted securities.

3. Managing funding and liquidity.

FINRA will examine firms’ ability to manage liquidity through the framework identified in its Regulatory Notice 15-33, which includes reviewing whether firms have evaluated their liquidity needs relative to both market-wide and idiosyncratic stresses, developed contingency plans to ensure sufficient capital and liquidity, and conduct stress tests to test their contingency plans. FINRA will also focus on high-frequency trading firms’ liquidity plans and controls.

4. FINRA’s other areas of focus in 2016.

In addition to the above-stated priorities, FINRA will continue to examine issues relating to the following areas:

  • Sales practices: Suitability, concentration, senior investors, sale charge discounts/breakpoints, 529 Plans, private placements, excessive charges in connection with new bond sales, and outside business activities.
  • Financial and operational controls: Market-maker net capital exemptions, ETF creation and redemption processes, fixed income prime brokerage, internal audits, client onboarding, and supervision of the transmittal of client funds to third parties.
  • Market integrity issues: Vendor display rule regarding quotations to customers, new compliance report cards, fixed-income markups, complying with Regulation SHO on closing out failures to deliver from naked short sales, cross market and cross-product manipulation, and integrity of audit trail processes.

The complete FINRA release, dated January 5, 2016, regarding its 2016 exam priorities may be accessed here:

If you have any questions about the topics covered above, please contact your regular Greensfelder contact, any member of Greensfelder’s Securities & Financial Services Group, or the authors of this client update, Don McBride and Megha Shah. 

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