Both the SEC and FINRA have indicated their examination priorities for broker-dealers in 2008: the SEC via a speech in early April by Lori Richards, OCIE Director; and FINRA via a March 24, 2008 letter to all members. Below follows a summary of the highlighted priorities:
A. Priorities Highlighted by Both the SEC and FINRA
1. Seniors and Retail Sales Practices. Both the SEC and FINRA emphasized that they have “devoted considerable resources” to protecting senior investors and baby boomers. Specifically, FINRA noted that it will focus on: sales pitches billed as educational seminars (e.g., the free lunch seminars about which the SEC published a report in September 2007); misleading advertising and sales materials; supervision; suitability, particularly with respect to life settlements and IRC 72(t) early withdrawals from retirement accounts; and salesperson designations as seniors experts.
2. Supervision. Supervision is a “core element” of any examination. The SEC and FINRA are particularly interested in: ensuring that current policies and procedures cover all business areas and are effectively enforced; designations of municipal OSJs; oversight of outside business activities; and supervision of producing branch managers.
3. Deferred Variable Annuities. Both agencies indicated that they will focus on firms’ compliance with NASD Rule 2821, the majority of which becomes effective on May 5, 2008.
4. Anti-Money Laundering. The SEC and FINRA have begun using a new uniform AML examination manual, which hopefully will provide some examination consistency. FINRA additionally highlighted FinCEN’s 2007 adoption of a final rule implementing part of § 312 of the USA PATRIOT Act, which requires firms to have enhanced due diligence procedures for certain foreign banking relationships.
5. Controls Over Non-Public Information. Both agencies indicated that they will focus on firms’ controls over non-public information and firms’ procedures designed to prevent the misuse of information and insider trading. The SEC indicated that it will look at more than the traditional forms of non-public information (such as information about upcoming deals), and will additionally look at customer orders, firm research, and customer credit. In January 2008, FINRA issued sweep letters designed to gather information about information barriers.
6. Protection of Customer Information. Information security has become an increasingly important examination focus for both agencies in light of an increase in intrusion (hacking) cases seen by the SEC. These cases raise Regulation S-P concerns, as well as AML and other suspicious activity issues. The SEC indicated it will additionally focus on business continuity plans and controls over customers’ change of addresses, account statements, and wire transfer arrangements.
7. Valuation. As certain markets have experienced downturns, the SEC’s and FINRA’s focus on effective controls over valuation has taken on new meaning. Firms may see an increased focus on valuation integrity in upcoming examinations.
8. Compliance with Trading Rules. Both agencies stated that they will continue to focus on best execution and compliance with various trading rules, such as Reg. SHO and Reg. NMS. FINRA’s March 2008 letter notes that many firms may incorrectly believe, because their market making or principal trading is de minimis, that Reg. NMS does not apply to them.
9. Suitability of Complex New Securities. With the increase of new securities products, many of which are complex, both agencies emphasized the need for firms to take a proactive approach at vetting new products and ensuring comprehensive suitability policies. FINRA noted that recent market events in the municipal bond market and auction rate securities give rise to suitability questions.
B. Additional SEC Priorities
10. Net Capital and Internal Controls. In light of recent market conditions, the SEC indicated that it will look at firms’ satisfaction of net capital requirements.
11. Fixed Income Securities. The SEC has indicated that it will review, among other things, pricing, markup, and suitability issues relating to fixed income products (such as CDOs and CMOs), as well as pay-to-play issues relating to municipal securities.
12. Conflicts of Interest. The SEC noted that it will look at revenue-sharing between broker-dealers and advisers who appear on the broker-dealers’ “recommended advisers” lists; indirect customer payments to gain access to IPOs; and sales of securities by affiliated firms.
C. Additional FINRA Priorities
13. Fee-Based Accounts. FINRA indicated that it will review how firms have handled fee-based brokerage accounts in light of the D.C. Circuit’s ruling in Financial Planning Assoc. v. SEC, which vacated Rule 202(a)(11)-1 under the Investment Advisers Act. Firms relying on Rule 206(3)-3T to trade on a principal basis with certain non-discretionary advisory accounts must be able to demonstrate compliance with all aspects of that temporary rule.
14. Transaction Reporting. FINRA indicated that it will continue to examine issues concerning the timely and accurate reporting of transactions. This will be a focus of FINRA’s automated surveillance and on-site examinations.
15. Bank Sweep Programs. FINRA stated that it will continue to examine broker-dealer programs sweeping customer credit balances into deposits at banks. The agency will focus on, among other things, procedures designed to ensure that customer funds are at all times protected, that minimum net capital requirements are met, that bank accounts are appropriately titled, and that accounts are treated correctly under SEC Rules 15c3-1 and 15c3-3. FINRA’s March 2008 letter cautions that “[f]irms are encouraged to contact their FINRA Coordinator if they are planning to enter into any new customer bank sweep program arrangements.”
16. Agency Lending Disclosure. FINRA will continue to focus on agency lending practices of firms that operate an agency securities lending business. According to the March 2008 letter, examiners will focus on, among other things, “pre-approval of principal counterparties, the adequacy of credit risk reviews performed, preparation of daily reconciliations at both the agent and underlying principal counterparty level, [and] maintenance of books and records at the principal counterparty level.”
17. Order Audit Trail Systems (OATS). FINRA noted that, effective February 4, 2008, OATS reporting requirements were expanded to include OTC equity securities. Additionally, effective February 4, 2008, other modifications to OATS were implemented to address Reg. NMS requirements and other issues.
18. Short Interest Reporting. FINRA noted that, effective September 2007, Rule 3360 was amended to increase the frequency of short interest reporting under that rule to twice a month.
Undoubtedly, examiners will review firms’ books, records, and operations regarding additional issues not noted above. However, given the notice that the SEC and FINRA have now provided, firms should expect, and therefore prepare for, a close review of the “hot topics” listed above.