A list of exam priorities are released annually by FINRA and the SEC in January. The Priority Letters, as the regulators have come to refer to them, are written and released to help firms under their respective regulatory schemes (generally anyone who will be reading this document) understand where their examiners will focus their attention when they come knocking on your door. Upon release, there is a general sense that maybe this year the information contained in these Priority Letters will actually provide insight to what will be important to the alphabet regulators. And, as with every year, we realize that these Priority Letters are filled with nuances, not details; generalities, not specifics; and a general disclaimer that the information contained herein does not constitute the full list of exam priorities. In essence, yes – everything is still important.
So, if we cannot count on these Priority Letters to inform us of what we should consider a priority, how should we use them? Each regulator gives its own structure to the Priority Letter they release, based on their constituents and mandate. As a consequence, the most valuable information must be found in those topics where the regulators intersect and name the same topics. These can be called Priority Intersections. There are six Priority Intersections identified in both Priority Letters this year. These are the topics that senior management and compliance officers should focus on this year in planning and execution.
Product Promotion (Incentive Structures)
Why? Conflict. Simply put, when reps (financial advisor, advisors, nomenclature of your choice) receive additional compensation to sell a specific product, it usually benefits the rep and the company creating the product. The same cannot be said for the clients who end up owning these products. Further, the products that reps are generally incented to place through these promotions are proprietary or complex products, which brings into question significant issues of suitability and potential fiduciary breaches.
On the face of the Priority Letter, it appears FINRA and the SEC arrive at this topic from different points. That is until you read deeper. Yes, FINRA is highly concerned with broker-dealers acting as Authorized Participants, but before you move on understand that the real concern is that ETFs are still fairly complex and must be sold, or used in asset allocation with a deep understanding of what they are and what they do. Suitability (a keyword in the FINRA Priority Letter), disclosures and concentration are areas that both regulators will be spending a significant time examining. This goes double for levered, inverse and new “alt” ETFs.
Due diligence, disclosure and suitability; these were the exact words used in both Priority Letters. Clients are relying on you almost 100% as it relates to purchasing a private placement, due to the lack of public information they can research. The regulators simply apply the responsibility to you. No amount of legal disclaimers will protect you in the eyes of an examiner if you have not done enough due diligence to understand the risks of an offering. Understanding those risks and potential benefits is of utmost importance: is this product suitable for that client you are talking to? Have you provided the client enough disclosure into your compensation on this product? Does your company get additional compensation on top of what you earn? Are there other conflicts a client should be aware of before they buy?
Anti-money Laundering (“AML”)
It does not matter if you are registered with a broker-dealer or a registered investment advisor, AML must matter to you. The majority of you reading this article just completed firm element continuing education before the December holidays, and undoubtedly those included an AML class. Most compliance officers either just completed or are preparing for their annual AML exam. Both of these items are driven by the firm’s AML program, which will be under significant scrutiny this year. The overall program will be looked at by examiners to ensure it is designed to monitor and assess transactions and client accounts to detect and report all suspicious activity. Additionally, the adequacy of the annual AML testing itself will be reviewed, ensuring the exam is specific to the company’s business and it is performed by independent experienced individuals.
This continues to be one of the focus areas for FINRA and the SEC. Firms have had over two full years to proceed through the process of creating a cybersecurity plan based on their business. This year, examiners of both regulators will expect their constituent firms to have documented programs that include written policies and procedures containing risk assessments, controls, response plans for the inevitable breach, vendor management and training. Firms need to take the time to assess where their cybersecurity plan is, and what needs to be addressed before the regulators are knocking.
Liquidity (Firm Funding)
Our industry is defined by negative events: Black Monday, the Tech Bubble, The Great Recession, and the Flash Crash. Clients remember these events, as do the regulators. Firm liquidity is a fairly quick note in both the Priority Letters. The overarching message is clear. Firms must be able to show that they have in place controls to monitor and address funding needs. Examiners will be focused on assessing if firms have the appropriate risk management tools to address their business models. Exams will be risk based, and will include stress testing based on such business models. Be prepared to discuss your firm’s liquidity contingencies, as they relate to trading and product management. Finally, individual reps should begin their own assessment of liquidity for the firm they are affiliated with, and their own pocket books. Examiners will be asking soon enough.
What is the signal? When everything is important, it can be difficult to evaluate what to prioritize. The Priority Letters, although valuable, often do not make it any easier. Experience tells us that when we start seeing Priority Intersections, this can be a sign of those areas where investments will realize the greatest return. Focus on these areas, what you and your firm have already done and what you can do to enhance policies in that respect.
Matthew Reynolds is the Chief Operating & Compliance Officer at Chicago, IL-based financial services firm Noyes, and its subsidiaries David A. Noyes & Company, Member FINRA and Noyes Advisors, LLC, a registered investment advisor with the SEC.
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