FINRA 2020 Exam Priorities Covering Sales Practices
On Jan. 9, 2020, FINRA released its 2020 Risk Monitoring and Examination Priorities Letter. Consistent with previous years’ priorities, a major portion of FINRA’s focus will be on broker-dealers’ sales practices. This update summarizes those priorities with the underlying rules and available guidance for the sale practice topics FINRA will focus on this year.
FINRA will continue to review sale practices in certain core areas, complex products, variable annuities, private placements, mark-up and mark-down disclosures for fixed income securities per Rule 2232(c), and representatives acting as trustee or POAs. FINRA will also continue to review firms’ policies and training designed to prevent improper advice to senior investors involving complex products, microcap or penny stock schemes, or outright fraud. To comply, firms should establish policies and provide training on what is required to obtain sufficient information from senior customers when they open accounts, how to handle certain issues that may be more common when working with senior investors, how and when to escalate issues relating to senior investors, and how to track those issues to ensure they are resolved and how they may be utilized to improve the experience for senior investors.
Notably, the SEC’s Office of Compliance Inspections and Examinations issued its 2020 exam priorities on Jan. 7, 2020, and it will also focus on senior investors, as well as investors who are teachers, veterans, or active-duty military. Indeed, in 2019, the SEC announced several initiatives focused on educating those groups, and in a recent interview, SEC Chairman Jay Clayton said, “For the most part, their money is long-term money. If they’re paying 250 [basis points] or 300 bps and they don’t know it, and they could be paying 15 or 20, that’s not good.” In light of this regulatory focus, it is appropriate to conduct supervision, surveillance, and/or compliance reviews that focus on recommendations and advice provided to those investors.
Regulation Best Interest and Form CRS
Prior to the June 30, 2020, compliance date for Regulation BI, FINRA will review how firms are preparing to implement the changes needed in light of this material change to the industry. It appears FINRA will be considering the Regulation BI Checklist it published on Oct. 8, 2019, as many of the stated priority considerations track those topics. After the effective date of Regulation BI, firms can expect FINRA to review what changes were made to comply, such as policies and procedures regarding conflicts disclosures, and the content and delivery of Form CRS. FINRA’s 2020 exam priorities cover these specific topics:
- Does a firm have procedures and training in place to ensure recommendations are in the best interest of the customer? This is a change from the suitability standard of FINRA Rule 2111, and it requires each recommendation to meet four core obligations – care, disclosure, conflicts of interest, and compliance – in addition to meeting the suitability standard.
- Does a firm apply the best interest standard to recommendations regarding the type of an account a customer should use? The decision to use a brokerage account versus an advisory account should consider the following: (1) services, features and products offered in the account; (2) projected costs of the account; (3) alternative types of accounts; (4) any services the customer may request; and (5) the customer’s investment profile. With respect to IRAs, additional considerations are (1) fees and expenses; (2) level of services available; (3) ability to take penalty-free withdrawals; (4) application of required minimum distributions, which now begin at age 72; (5) protections from creditors and judgments; (6) holdings of employer stock; and (7) any special features of the existing account.
- Whether account monitoring is offered and accepted by a customer. While there is no duty to monitor, if it is agreed to the best interest standard will apply to both explicit and implicit hold recommendations. Review and recommendations will be required per the specified, periodic basis that is agreed to. Consequently, a firm's silence will represent an implicit recommendation to hold and must be in the best interest of the customer.
- Do a firm and associated persons consider the express new elements of care, skill and costs when making recommendations to retail customers? The reasonable-basis and customer-specific suitability obligations set forth in FINRA Rule 2111(a) still apply. However, Regulation BI adds elements of care, skill and cost to the analyses. Care and skill require one providing a recommendation to understand the risks and rewards of the recommendation and have a reasonable basis that it is in the best interest of the customer at the time of the recommendation. The cost factor is not limited to the immediate, up-front cost of a particular purchase, but also includes expected costs from the future sale or exchange of a security, any deferred sales charges, or liquidation costs. Moreover, costs of reasonably available alternatives offered by the firm should also be considered but should not be the end-all consideration. To be sure, FINRA has stated the cost element "is not intended to limit or foreclose a recommendation of a more costly product if there is a reasonable basis to believe that the product is in the best interest of a particular retail customer.”
- Do a firm and associated persons consider reasonably available alternatives to a specific recommendation? What other alternatives are offered by the firm? Are they lower cost? Firms should establish a process – reasonable within their business models – to identify the scope of reasonably available alternatives when certain products and strategies are considered for a recommendation.
- Do a firm and associated persons guard against excessive trading, even if they do not control an account? Regulation BI requires that a recommended series of transactions – regardless of whether a firm exercises actual or de facto control over an account – is not excessive and is in the best interest of the customer. This removes the element of actual or de facto control required by quantitative suitability in FINRA Rule 2111(a).
- Does a firm have policies and procedures to provide the Regulation BI disclosures? These include:
(a) Whether a recommendation is made in the capacity as a broker-dealer or an investment advisor. FINRA has stated that for dually registered firms/individuals, Form CRS will not be sufficient to disclose the specific capacity for a particular recommendation. Likewise, any limitation, such as an associated person not registered as an IAR, but working for a dually registered firm or otherwise registered in a limited capacity (Series 6), must also be disclosed;
(b) Material fees and costs that apply to a retail customer's transactions, holdings and account. This does not require individualized disclosure for each customer, however, it must be more specific than the fee/cost disclosure in Form CRS. Standardized numerical, reasonable dollar or percentage ranges are permissible;
(c) Whether the firm will be providing account monitoring services, and if so, the scope and frequency of such services;
(d) What the requirements are for a retail customer to open and maintain an account, such as minimum account size or other thresholds that will result in lower or avoided fees;
(e) Whether there are material limitations on the types of securities or investment strategies offered by the firm. This would include if a firm limits recommendations to proprietary products, specific asset classes, or products offered via third-party arrangement;
(f) A standardized summary of the basis for recommendations, such as a firm's investment approach/philosophy/strategy. The disclosure should also inform the customer of how a firm will notify them when a standardized basis does not apply to a recommendation; and
(g) Risks associated with a recommendation, which may be in a standardized disclosure.
- Does a firm have policies and procedures reasonably designed to identify and address conflicts of interest? Regulation BI defines a “conflict of interest” as “an interest that might incline a broker, dealer, or a natural person who is an associated person of a broker or dealer – consciously or unconsciously – to make a recommendation that is not disinterested.” As an example, the SEC's 2020 exam priorities provides “fee and compensation-based conflicts of interest may take many forms, including revenue sharing arrangements between a registered firm and issuers, service providers, and others.”
- Does a firm have policies and procedures in place regarding the filing, updating and delivery of Form CRS? The form must be filed on Web CRD, and dual registrants must file using both Web CRD and IARD. Delivery to new customers must be made before or at the earliest of: any recommendation of an account type, transaction, placing an order, account opening or implementation of an investment strategy. If in a packet of information, Form CRS must be placed first. For existing customers, delivery must take place within 30 days after the date by which the form must be electronically filed with the SEC, which would include providing it with June 2020 account statements, as long as it is placed first in the packet.
Communications With The Public
For 2020, FINRA states that it will focus on retail communications relating to private placements and communications via digital channels, including supervisory and recordkeeping requirements per Rule 2210.
Private Placement Retail Communications: The content standards of FINRA Rule 2210(d)(1)(A) provide “All member communications must be based on principles of fair dealing and good faith, must be fair and balanced, and must provide a sound basis for evaluating the facts in regard to any particular security or type of security, industry, or service. No member may omit any material fact or qualification if the omission, in light of the context of the material presented, would cause the communications to be misleading.” Rule 2210(d)(1)(B) provides “No member may make any false, exaggerated, unwarranted, promissory or misleading statement or claim in any communication. No member may publish, circulate or distribute any communication that the member knows or has reason to know contains any untrue statement of a material fact or is otherwise false or misleading."
FINRA’s exam priorities indicate it expects a disclosure that private placements “may involve a high degree of risk, are not liquid, and that investors may lose money.” Any issuer-specific risks must also be disclosed and, of course, any false or misleading information about future public offerings, future success of new or untried business models, or regulatory risk of the offering may not be stated. Forecasts of issuer metrics must be reasonable and include clear explanations of the underlying assumptions and corresponding risks that could disrupt those assumptions. Finally, communications may not predict or project performance, subject to the limited exceptions of FINRA Rule 2210(d)(1)(F), or imply that past performance will recur.
Finally, it is worth noting that Regulatory Notice 10-22 sets forth what FINRA expects with respect to conducting reasonable investigations and due diligence prior to recommending an offering in a private placement. This includes evaluating each separate offering by an issuer, conducting an independent review of any due diligence conclusions by consultants or vendors, and consideration of any conflicts resulting from third-party due diligence paid for by the issuer. Firms should document what they reviewed, who they spoke to, what sources were used, and all other efforts of due diligence over a private placement offering.
Communications via Digital Channels: FINRA will focus on how firms review and retain digital communications — texting, instant messaging, social media communications, and other chat or messaging applications. As background, FINRA previously issued Regulatory Notice 17-18 to provide guidance on what is expected with respect to social media and text message communications. In 2020, FINRA will review whether firms have a process to evaluate new tools to determine whether there are digital communication channels that should be captured (i.e. included in routine electronic communications supervisory review and stored per books and records requirements). Are firms periodically testing their systems to determine their effectiveness? Are supervisors trained to identify and respond to “red flags” that indicate a registered representative may be using unapproved communication channels? Such indicators would include communications that reflect unapproved email addresses, references to unapproved communications outside of an email, or customer complaints that reference such communications.
Cash Management and Bank Sweep Programs
FINRA is concerned that some member firms may not be communicating adequate information to retail customers about sweep arrangements. For example, some customers may question whether their cash position is protected by FDIC deposit insurance, particularly those balances in excess of $250,000.
During its 2020 exams, FINRA will consider whether (1) the nature of the sweep arrangement and any available alternatives have been clearly communicated; (2) there have been any mistaken implications that a brokerage account money market position is the same as a FDIC-insured deposit account; (3) statements accurately reflect deposits held at a bank are bank obligations, and not cash balances in a brokerage account; (4) a firm has a written policy/procedure in place to perform reconciliations of customer balances held at each bank; (5) customer balances not yet swept to a bank are included as a customer credit in the reserve formula computation; and (6) there have been any material misrepresentations relating to FDIC coverage, nature/structure of the accounts, the relationship between the firm and the third-party bank, or any risks of participating in the program.
Sales of Initial Public Offering Shares
In 2020, FINRA will review procedures designed to detect and address “flipping” and “spinning.” Flipping involves an investor purchasing an IPO at a relatively low offering price and selling it within 30 days for a quick gain. FINRA Rule 5131(c)(1) provides “No member or person associated with a member may directly or indirectly recoup, or attempt to recoup, any portion of a commission or credit paid or awarded to an associated person for selling shares of a new issue that are subsequently flipped by a customer, unless the managing underwriter has assessed a penalty bid on the entire syndicate.” Rule 5131(c)(2) provides “In addition to any obligation to maintain records relating to penalty bids under SEA Rule 17a-2(c)(1), a member shall promptly record and maintain information regarding any penalties or disincentives assessed on its associated persons in connection with a penalty bid.” Finally, FINRA Rule 5131(b) generally prohibits “spinning,” which involves a firm acting as an underwriter distributing IPO shares to an officer or director of a company that is an investment banking services client of the firm.
FINRA will also review: (1) whether firms generate reports to issuer pricing committees to track aggregate retail demand; (2) processes to develop and implement IPO allocation methodologies; (3) controls designed to prevent allocations to restricted persons per FINRA Rule 5130(i)(10); and (4) what is done to obtain, record and verify customer information of investors receiving IPO allocations.
FINRA is concerned that some registered representatives may be exercising discretion without customer authorization or firm approval. FINRA Rule 3260(b) provides “No member or registered representative shall exercise any discretionary power in a customer’s account unless such customer has given prior written authorization to a stated individual or individuals and the account has been accepted by the member, as evidenced in writing by the member or the partner, officer or manager, duly designated by the member, in accordance with Rule 3110.” If discretion is permitted, FINRA Rule 3260(c) requires a firm to “review all discretionary accounts at frequent intervals in order to detect and prevent transactions which are excessive in size or frequency in view of the financial resources and character of the account.”
FINRA priorities will include (1) reviewing how firms conduct surveillance to target unauthorized/unapproved discretion; (2) how supervisors are trained to detect red flags that indicate unauthorized/unapproved discretion, and what follow up steps to take to investigate the situation; and (3) what firms do to identify trades that are inappropriately marked unsolicited.
The complete FINRA release, dated Jan. 9, 2020, regarding its 2020 exam priorities may be accessed here.
 Additional 2020 areas of FINRA priorities are: Market Integrity (direct market access controls, best execution, disclosure of order routing information, and the vendor display rule found in Regulation National Market System Rule 603), Financial Management (digital assets, liquidity management, underwriting compliance with Exchange Act Rule 15c3-1(c)(2)(viii), and the phase-out of the LIBOR benchmark at the end of 2021), and Firm Operations (cybersecurity and technology governance).
 Notably, on Nov. 5, 2019, Stephanie Avakian, Co-Director of the SEC's Division of Enforcement said during an interview: “We are also looking at cash sweep arrangements. Cash in advisory accounts is often automatically swept into a money market mutual fund or a bank deposit sweep program. A dually-registered adviser or an adviser with an affiliated broker-dealer may have a financial interest, a conflict, in recommending one cash investment over another. For example, some money market mutual funds carry 12b-1 fees or make revenue sharing payments that may be shared with a dually-registered adviser or an adviser’s affiliated broker-dealer, while other money market funds do not carry those fees. Advisers recommending or choosing between different money market funds must make full and fair disclosure of these types of conflicts to their clients. The Commission has brought enforcement actions in the past where advisers have failed to make appropriate disclosure.”