This is part three in a four-part series on the SEC’s examination priorities for 2020. 

In this third article in our series, we will address key takeaways from the Financial Industry Regulatory Authority’s (FINRA) 2020 Risk Monitoring and Examination Priorities Letter (the Letter). The priorities are released annually and discuss the focus areas for the coming year. The 2020 letter continues last year’s effort to address new and emerging areas.

Firms that are also registered investment advisers or investment companies should review our previous articles as well.

Regulation Best Interest and Form CRS

On June 5, 2019, the SEC adopted Regulation Best Interest (Reg BI), which establishes a “best interest” standard of conduct for broker-dealers and associated persons. The regulation created a new disclosure document, the Client Relationship Summary (Form CRS). Form CRS is a two-page, plain English narrative and contains certain details about the firm’s business, compensation, and disclosures of conflicts of interest. Firms must comply with Reg BI and Form CRS by June 30, 2020.
Early exams will focus on firms’ preparedness for Reg BI to better understand implementation challenges. After the compliance date, firms will be examined on their compliance with Reg BI, Form CRS and related SEC guidance. Importantly, the regulation defines “retail clients” to include all individual, natural persons regardless of their net worth.

Among other things, examiners will look at how a firm applies the best interest standard to the recommendations it makes, and how it guards against excessive trading, regardless of whether the broker-dealer or associated person “controls” a given account.

Communications With the Public

FINRA will continue to assess firms’ compliance with obligations relating to FINRA Rule 2210 (Communications with the Public), as well as related supervisory and recordkeeping requirements set forth in FINRA Rule 3110(b)(4) (Supervision), FINRA Rule Series 4510 (Books and Records Requirements) and Securities Exchange Act of 1934 (Exchange Act) Rules 17a-3 and 17a-4 (Books and Records Requirements).
In particular, examiners will look at how firms:

• Review, approve, supervise and distribute retail communications regarding private placement securities.
• Review and retain electronic communications, given the increased use and variety of communication channels available.

Cash Management and Bank Sweep Programs

FINRA is concerned that, while these programs may be useful to customers, they may also have disadvantages, including higher than average interest rates. Among other considerations, examiners will assess:

• How firms communicate the nature of these arrangements, particularly their terms and whether there are any alternative arrangements available.
• Whether any descriptions are inaccurate or misleading (e.g., implications that brokerage accounts are the same as or similar to bank accounts).
• Clarity of disclosures that the Bank Sweep Program deposits are obligations of the destination bank, and not cash balances held by the firm.
• Written policies and procedures to reconcile customer balances at each destination bank in the Bank Sweep Program.
• How a firm treats balances not yet swept into a destination bank.

Initial Public Offerings

2019 saw an uptick in IPO activity; accordingly, FINRA plans to focus on firms’ obligations under FINRA Rules 5130 (Restrictions on the Purchase and Sale of Initial Equity Public Offerings) and 5131 (New Issue Allocations and Distributions).
Firms should have policies and procedures to:

• Detect potential instances of flipping and spinning.
• Prevent allocations to restricted persons.
• Collect, document and verify customer information.

Finally, examiners will focus on how firms develop and implement their IPO allocation methodologies.

Trading Authorization

Firms should have reasonably designed supervisory systems for trading authorization, discretionary accounts and key transaction descriptors, such as solicitation indicators. In addition, firms should be able to detect and address registered representatives exercising discretion without written authorization from the client, as required under FINRA Rule 3260 (Discretionary Accounts). Examiners will review protocols to detect red flags that a registered representative is exercising discretion without authorization, specifically:

Direct Market Access Controls
Examiners will assess firms’ compliance with Exchange Act Rule 15c3-5 (Market Access Rule), focusing on key controls such as:

• Management of technology changes for systems associated with market access, and what controls exist to monitor and respond to anomalies in trading algorithms or caused by market events.
• Adjustments to credit limit thresholds for institutional customers.
• Use of automated controls to timely revert ad hoc credit limit adjustments.
• Due diligence on any third-party vendors that the firm uses to comply with the rule.
• Providing training to individual traders regarding the steps and requirements for requesting ad hoc credit limit adjustments.

Best Execution
Firms must exercise reasonable diligence to determine whether their customer order flow is directed to the best market given the size and types of orders, the terms and conditions of orders, and other factors as required by FINRA Rule 5310 (Best Execution and Interpositioning).   In particular, examiners will consider:

• Potential conflicts of interest in order routing decisions, including the impact of the recent increase in zero-commission brokerage activity.
• Whether firms are filling customer odd-lot orders at the NBBO disseminated by the SIPs and offsetting these trades with odd-lot executions at superior prices reflected in the exchanges’ proprietary data feeds.
• The reasonableness of firms’ policies and procedures for best execution and fair pricing for U.S. Treasury securities.
• Whether option orders received inferior execution prices. This is in response to numerous customer complaints typically involving small volume option executions at various prices followed by a larger execution for the remainder of the order at inferior price levels.

Disclosure of Order Routing Information
The amended Regulation National Market System (NMS) Rule 606 requires broker-dealers to provide new customer-specific reports for not held orders in NMS stocks. Among other things, examiners will review:

• Compliance with layout and format requirements, including the presence of all required components of the report.
• Policies and procedures to address the accuracy and timeliness of published reports.
• Policies and procedures to determine if customers’ order activity falls below the relevant reporting thresholds.
• Whether a firm assesses its use of third-party order routing and execution services.
• How the firm will obtain the necessary data to prepare the reports.

Vendor Display Rule
Rule 603 of Regulation NMS (Vendor Display Rule) generally requires broker-dealers to provide a consolidated display of market data for NMS stocks for which they provide quotation information to customers. FINRA will evaluate the adequacy of firms’ controls and supervisory systems, including the following:

• Systems or platforms used to provide quotation information to customers.
• Monitoring to ensure that current quotation information is distributed to customers.
• Procedures to review the quotation information received to determine whether it complies with the rule.

Digital Assets
Increasingly, New Member Applications (NMAs) and Continuing Member Applications (CMAs) include business activities related to digital assets, such as private offerings of digital asset securities, operating secondary trading platforms or facilitating trades of indirect investment products (e.g., private funds investing in cryptocurrencies). We note that this is also a priority area for the SEC.

Examination topics will include:

• Whether the firm has filed or will be filing a CMA.
• Descriptions and disclosures in marketing materials and retail communications.
• Controls and procedures to trade in digital assets, including initial issuance or secondary market trading.

Liquidity Management
Exams will focus on areas that FINRA addressed in Regulatory Notice 15-33 (Guidance on Liquidity Risk Management Practices) and others that may impact firms’ contingency funding plans. In particular:

• Assessment of specific stress conditions and identification of staff responsible for addressing them.
• The process for accessing liquidity during a stress event, and determining how the funding would be used.
• Whether the plan considers the quality of collateral, term mismatches and potential counterparty loss of financing desks (specifically in repo and stock loan transactions).

Contractual Commitment Arising from Underwriting Activities
FINRA will review firms’ compliance with Exchange Act Rule 15c3-1(c)(2)(viii), including:

• Understanding of the nature of the underwriting and documentation of all deals that the firm engages in.
• Procedures to assess moment-to-moment and open contractual commitment capital charges.
• How regulatory reporting teams track the appropriate net capital treatment of the underwritings.

London Interbank Offered Rate (LIBOR) Transition
Also noted by the SEC with respect to registered investment companies, FINRA is interested in how the industry is preparing for LIBOR’s retirement at the end of 2021.  Though not part of the exam program per se, FINRA will consider firms’ exposure to LIBOR-linked financial products, steps firms are taking to plan for the transition to alternative rates, and the impact of the LIBOR phase-out on customers.

Technology
Given the rapid increase in how firms use technology to communicate with customers and business partners, FINRA will thoroughly assess whether cybersecurity policies and procedures are reasonably designed to protect customer records and information consistent with Regulation S-P Rule 30.

Similarly, firms’ reliance on technology for virtually all of their key operations can expose firms to operational failures that may negatively impact compliance with, among others, FINRA Rules 4370 (Business Continuity Plans and Emergency Contact Information), 3110 (Supervision) and 4511 (General Requirements), as well as Exchange Act Rules 17a-3 and 17a-4.

We encourage you to review the entire Letter, which is available here. The Appendix includes additional links that will be of interest. As you consider the applicability of these priorities to your business, we encourage you to reach out to one of our broker-dealer experts.