Continuing With Business Conduct and Sales Practice Priorities.

[ by Howard Haykin ]

On Tuesday, in Part One of our review of FINRA's 2013 priorities, we followed FINRA's discussion on "suitability and complex products."   We identified characteristics and related risks of various types of complex securities, the concerns FINRA has with each, and suggested controls and supervisory procedures firms can use to address those expressed risks and concerns.  To read that posting, go to: [FINRA Regulatory & Exam Priorities – Part One, 1/14/13]

Today, we stay with "Business Conduct and Sales Practice Priorities," but deal with these other areas:

• Cyber-Security and Data Integrity
• Microcap Fraud
• Private Placement Securities
• Anti-Money Laundering.

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Cyber-Security and Data Integrity.   Throughout 2012, the financial services industry experienced an increasing number of cyber-security issues - which threatens the safety and integrity of sensitive customer data.  Computer servers of financial companies were frequently hacked, exposing target firms to disruption of service and and unauthorized access to customer account information.  In 2013 and beyond, the risks are certain to expand, which means firms must take whatever proactive measures are practicable. 

FINRA's primary concern is the integrity of firm policies, procedures and controls to protect sensitive customer data.  To that end, FINRA will evaluate such controls during exams, sweeps and targeted investigations.
 

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Microcap Fraud.   High-risk, speculative microcap and low-priced OTC securities are regularly touted to investors through telemarketers, promotional emails and brochures delivered to investors’ homes through the U.S. mail.  Firms should review their policies and procedures to ensure that activities
at the firm related to microcap and low-priced OTC securities are compliant with FINRA rules and federal securities laws.

Examples of such policies and procedures include:

• heightened supervision of firm employees who maintain direct or indirect outside business activities associated with microcap and OTC companies;
• heightened supervision of traders involved in trading microcap and low-priced OTC securities;
• ensuring that any firm research on microcap and low-priced OTC companies is accurate and balanced, while appropriately disclosing risks; 
• monitoring for unregistered distributions of company stock in those customer accounts liquidating microcap and low-priced OTC securities;
• heightened supervision of firm activities where an affiliate of the firm is the transfer agent for microcap or low-priced OTC securities;
• implementing AML responsibilities pertaining to monitoring for suspicious activity and the filing of SARs (Suspicious Activity Reports) where warranted; and,
• monitoring broker solicitations of customers to trade microcap and low-priced OTC securities, ensuring that any recommendations are balanced and that securities are suitable for the relevant customers.

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Private Placement Securities.   FINRA continues to be concerned about the sale and marketing of private placement securities.  FINRA Rule 5123 facilitates FINRA's understanding of these offering with the following requirements:

• member firms, upon selling an issuer’s securities in a private placement to individuals, must file with FINRA a copy of the offering document.  
• FINRA will use this information to enhance its risk-based supervision of this market and to better identify and assess higher-risk transactions.

FINRA also reminds member firms about the relative scarcity of independent financial information and the uncertainty surrounding the market.  Those factors, plus credit-risk exposures associated with many private placements, necessitate reasonable due diligence on prospective issuers, that focuses on:

• an issuer’s creditworthiness,
• the validity and integrity of the issuer's business model;
• the plausibility of expected rates of return as compared to industry benchmarks - particularly in light of the complex fee structures associated with many of these investments.

FINRA is primarily concerned that inadequate due diligence in private placements can and will could expose customers to harm and lead to insufficient disclosure.  To that end, FINRA examiners will focus on:

• due diligence policies and procedures,
• valuation processes,
• integrity and independence of 3rd-party valuation services, and,
• timely disclosure of material risks.

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Anti-Money Laundering.   AML compliance remains a big priority for examiners, particularly with those firms having higher-risk business models due to their clients, products and service mix, or location in which they operate.  Last year's DOJ case against HSBC highlighted, among other things, potential risks associated with foreign affiliates and the business they transact through their U.S. financial institution affiliates.

In FINRA exams, examiners have seen an increase in forex (foreign currency) conversion transactions, in which:

• foreign financial institutions purchase U.S.-denominated bonds - generally issued by foreign governments - with the local currency, which then are transferred to a U.S. broker-dealer and sold, with proceeds then transferred offshore.
• U.S. broker-dealers that act as intermediaries in these transactions may receive foreign bonds or other securities worth millions of U.S. dollars without knowing who or how many underlying customers may be involved.
• Reviews of this business have raised concerns regarding the level of due diligence performed by firms.
• Reviews also have disclosed inadequate monitoring by firms for potential suspicious activity.

With money laundering risks continually changing, firms must stay vigilant in reviewing for suspicious activity and must adapt their AML programs accordingly.  To this end, FINRA examiners will continue to focus on AML issues from the fundamentals to more esoteric issues, as the financial economic crime environment continues to change.
 

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Concluding Notes:   FINRA encourages firms to use the information in this letter to enhance their supervisory and compliance programs to mitigate risk and better protect investors. As always, firms may contact their Regulatory Coordinator with specific questions or comments.  Firms may also contact Daniel Sibears, FINRA EVP, Member Regulations Programs, with their general comments or suggestions on how the letter can be improved. 

To access a copy of the letter, go to:   [FINRA Regulatory and Examination Priorities for 2013, 1/11/13].