This February, the Financial Industry Regulatory Authority, Inc. ("FINRA") released its Report on FINRA's Examination and Risk Monitoring program (the "Report").1 The Report replaces FINRA's former Report on FINRA Examination Findings and Observations, and its Risk Monitoring and Examination Priorities Letter. The Report, in its new format, will be released annually.
The Report covers a broad spectrum of issues. This article focuses on areas of interest to the structured products industry.
REGULATION BEST INTEREST
This part of the Report generally asks firms whether they have policies, procedures and controls in place to implement all aspects of Regulation Best Interest, including relating to recommendations, record keeping, disclosures and training. There are also inquiries relating to the use of Form CRS. FINRA Rule 2111 (Suitability) is still relevant, as the Report asks whether a member firm's "policies, procedures and controls continue to address compliance with FINRA Rule 2111 (Suitability), which still applies to recommendations made to nonretail investors .."2
COMMUNICATIONS WITH THE PUBLIC (FINRA RULE 2210)
FINRA reminds firms that all communications must be fair, balanced and not misleading, noting that if a communication promotes the benefits of a high-risk or illiquid security, it should also explain the associated risks. In particular, the Report asks "[d]o your firm's communications balance specific claims of investment benefits from a securities product or service (especially complex products) with the key risks specific to that product or service?"3
The Report reflects FINRA's concerns about the use of digital communication channels and digital assets, as summarized below:
- Whether a firm's digital communication policy addresses all permitted and prohibited digital communication channels and features available to customers and associated persons;
- Whether the firm reviews for red flags that may indicate a registered representative is communicating through unapproved communication channels, and whether there is any follow up on such red flags;
- How a firm supervises and maintains books and records in accordance with SEC and FINRA rules for all approved digital communications;
- If a firm offers an app to customers that includes an interactive element, whether the information provided to customers constitutes a "recommendation" that would be covered by Regulation Best Interest, which requires a broker-dealer to act in a retail customer's "best interest," or suitability obligations under FINRA Rule 2360 (Options);
- If a firm's app platform design includes "game-like" aspects that are intended to influence customers to engage in certain trading or other activities, whether the firm addresses and discloses the associated potential risks to its customers; and
- Whether a firm's communications-regardless of the platform through which they are made-comply with the content standards set forth in FINRA Rule 2210.4
FINRA's question on whether a member firm's app platform includes "game-like" aspects follows on the heels of a complaint by the Massachusetts Secretary of State, Securities Division, against a FINRA member, alleging, among other things, the "use of strategies such as gamification to encourage and entice continuous and repetitive use of its trading application .."5
The Report includes a section, titled "Emerging Digital Communication Risks - New Digital Platforms With Interactive and 'Game-Like' Features," in which FINRA, while acknowledging that such features may improve access to firm systems and investment products, warned that these features may increase risks to customers if not designed with appropriate compliance considerations in mind. In this context, FINRA reminds firms to meet regulatory obligations relating to, among others:
- Regulation Best Interest and Form CRS if any communication constitutes a recommendation to a retail customer;
- Disclosing risks relating to fees, costs, conflicts of interest and required standards of conduct;
- Ensuring that all communications are fair and balanced;
- Developing a comprehensive supervisory system, including identifying red flags and maintaining proper record keeping; and
- Complying with FINRA's communication rules.6
Member firms' activities relating to digital assets are also scrutinized, with two questions relating to potential investor confusion about the characteristics of digital assets:
- Does your firm provide a fair and balanced presentation in marketing materials and retail communications, including addressing risks presented by digital asset investments, and not misrepresenting the extent to which digital assets are regulated by FINRA or the federal securities laws or eligible for protections thereunder, such as Securities Investor Protection Corporation coverage?
- Do your firm's communications misleadingly imply that digital asset services offered through an affiliated entity are offered through and under the supervision, clearance and custody of a registered broker-dealer?7
The exam findings noted deficient digital assets communications by member firms, including false, misleading or unwarranted statements. With respect to digital communications, examinations found insufficient supervision and record keeping to be a problem.
BOOKS AND RECORDS
Under the applicable books and records requirements, a member firm must create and preserve, in an easily accessible place, originals of all communications received and sent relating to its "business as such." These records may be maintained and preserved for the required time on electronic storage media, subject to certain conditions.
FINRA asks in the Report what kind of vendors, including cloud service providers, a member firm uses to comply with the books and records rules requirements, and suggested reviewing vendor contracts to confirm that these comply with those requirements. Exam findings had uncovered that some member firms had not performed sufficient due diligence on third party vendors as to whether they had the ability to comply with the books and records rules requirements.
FIXED INCOME MARK-UP DISCLOSURE
Under FINRA Rule 2232, member firms are required to provide additional transaction-related information to retail customers for certain trades in corporate, agency and municipal debt securities. Disclosed mark-ups and mark-downs must be expressed as both a total dollar amount for the transaction and a percentage of prevailing market price (PMP). The considerations listed by FINRA in the Report relate to how member firms review the accuracy of reporting under Rule 2232 in customer confirmations.
Two items in the examination findings are of note:
- Disclosure for Structured Notes - Failing to provide disclosures on customer confirmations for trades in TRACE-reportable structured notes because firms did not realize the notes were subject to FINRA Rule 2232 or did not receive the PMP from the structured note distributors; and
- Incorrect Designation of Institutional Accounts - Failing to provide disclosures to certain customers because the firm identified those customers' accounts as "institutional," even though the customers did not meet the "institutional" definition in FINRA Rule 4512(c) (Customer Account Information).8
Originally published in REVERSEinquiries: Volume 4, Issue
Click here to read the articles in this latest edition.
1. The Report is available at: https://bit.ly/3rsCbBK.
2. Report at 18.
3. Id. at 19.
4. See the Report at 20.
5. See In Re Robinhood Financial, LLC at 2, available at: https://www.sec.state.ma.us/sct/current/sctrobinhood/MSD-Robinhood-Financial-LLCComplaint-E-2020-0047.pdf.
6. See the Report at 22.
7. Report at 20.
8. Report at 17.
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