Insider Trading and Financial/Operational Priorities. 

[ by Howard Haykin ]

We're past FINRA's #1 priority for 2013 - "Business Conduct and Sales Practice Priorities" and now moving onto 2 huge and critical priorities in 2013 or any year:  (i) Insider Trading;  and, (iii) Financial and Operational Priorities.

But first, to read any of C-I's first 3 postings, click and read:  

[FINRA Reg'y & Exam Priorities – An Introduction]  

[FINRA Reg'y & Exam Priorities - Suitability & Complex Products] 

[FINRA Reg'y & Exam Priorities – Cyber Security, Microcap Fraud, Pvt Placements, AML]

               
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Insider Trading

For this perennial top regulatory priority, FINRA asks firms to stay vigilant by:  (i) safeguarding material, non-public information, and, (ii)  periodically assessing information barriers and risk controls to ensure they're adequate.

Some suggested risk controls firms might like add to their compliance systems and policies: 

• routine review of e-communications of personnel within business units that typically come into contact with material, non-public information - e.g., investment banking and research;

• maintaining appropriate information-barrier policies and procedures, designed to limit or restrict the flow of material, non-public information within the firm to employees on a “need-to-know” basis;

• monitoring employee trading activity, both inside and outside the firm, to identify suspicious activity;

• conducting regular reviews of proprietary and customer trading in securities placed on a watch/restricted lists;

• conducting employee training on the use and handling of material, non-public information; and,

• implement a process for ID'g suspicious customer trading in securities of their employer or corporate affiliates.

             
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Financial and Operational Priorities

Today’s difficult economic environment can challenge most firms' ability to adequately fund their operations under various stress conditions.  That is why FINRA examiners will focus significant attention on net capital issues and protection of customer assets - as well as on that perennial favorite, "accuracy and integrity of firms’ books and records."

Expect FINRA staffers to review, among other things, implementation of Generally Accepted Accounting Principles (GAAP) and the accurate recording and reporting of required liabilities, securities valuation, and the impact of market, credit and liquidity risk concentrations on the balance sheet.

Guarantees and Contingencies.   GAAP requires firms to determine the dollar amount of losses that could result from guarantees or contingencies, and accrue such losses in computing their net worth when occurrence is probable and the amount can be reasonably estimated. 

Yet, recent net capital reviews reveal that firms are deficient in accounting for guarantees and contingencies.  While recent deficiencies have centered on contingencies resulting from legal matters and guarantees of 3rd-party financial obligations, FINRA expects to focus on whether firms are identifying all contingencies and guarantees, and are documenting the basis for any associated liability accrual or lack thereof.

Among the issues that FINRA examiners will continue to pursue are, the following:

• Ascertain compliance with the requirements of SEA Rule 15c3-1c(d) when a firm guarantees, endorses or assumes, directly or indirectly, any obligation or liability of a subsidiary or affiliate. 

Examiners will seek to determine that such obligations or liabilities are properly reflected as a deduction from net worth in the computation of net capital, and are included in the calculation of aggregate indebtedness, as applicable, absent a consolidation.

• Ascertain that adverse awards in arbitration proceedings are recorded by the firm as a liability at the time award is made, even though the award might be on appeal or is under consideration by a court.

• Ascertain that any firm subject to an adverse SRO, administrative or court judgment, or to a lawsuit - that could have a material impact on its net capital - has recorded a liability for the adverse judgment or lawsuit;  alternatively, the firm may obtain an opinion of outside counsel re: the potential effect of such an action on the firm’s financial condition

- see interpretation to the SEA Rule 15c3-1 (Net Capital Rule)).

• Absent such opinion, firms will be asked to demonstrate the basis of their determination to not record a liability.  At a minimum, any such adverse judgments or lawsuits would be a contingent liability and must be included in aggregate indebtedness.

• Ascertain that any firms entering into arrangements to guarantee the satisfaction of financial obligations of 3rd parties or affiliated entities, have included their parent, where such arrangements were not comprehended in the firm’s computation of its net capital. Guarantees to repay or satisfy the financial obligations of 3rd parties or related parties may result in net capital charges up to the full amount of such obligations.

• Ascertain for any firm that pledges allowable assets as collateral to secure a 3rd party’s financial obligation, as to whether that firm is required to treat such assets as non-allowable and should be deducting them from net worth for net capital computation.

Margin Lending Practices.   The valuation and marketability of certain securities that collateralize margin receivables raise concerns when margin loans are collateralized by thinly traded equities, municipal bonds and highly structured CMOs (collateralized mortgage obligations). FINRA has seen situations where these securities have represented concentrated positions in a single account, which might mean that a publicly quoted market value may not be representative of the liquidation value of the security - and that a firm may realize a loss upon liquidation if the customer fails to meet a margin call.

• Firms will be expected to have a governance process to judiciously determine whether extensions of credit are appropriate on various asset classes, and to determine the amount of margin that should be extended on less-liquid positions. 

• Also, as more swaps move to a central clearing facility, firms acting as principal or as clearing agent for these swap transactions will need to determine, using independent risk techniques, whether the clearing house margin is adequate or whether additional house margin should be collected.

Leverage and Liquidity.   With interest rates at historic lows, some firms continue to increase their balance sheet to compensate for the lower net-interest revenue, but then fail to adequately pay attention to possible maturity mismatch of assets and liabilities.

In fixed-income instruments, firms may not be subjecting themselves to significant interest-rate risk but may be unduly exposed to liquidity risk, particularly when the asset side of the balance sheet is a reverse repurchase transaction or margin loan with no stated maturity.

FINRA examiners will, therefore, review steps taken by firms - e.g., extending the maturity of their liabilities to better match their assets.

FINRA continues to ID firms with large complex balance sheets that rely exclusively on their parent company for contingency funding.  FINRA examiners will review whether such firms regularly assess their funding and liquidity risk at the broker-dealer on a standalone basis, then follow up by with necessary steps to be in a position to operate under adverse circumstances.

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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].