Firm culture, sound procedures for new product reviews and for recommending rollovers are on FINRA’s to-do list for 2015.
Over the ten years FINRA has been issuing its annual letter, big changes have taken place, according to the regulator. Analytics have allowed FINRA to identify registered representatives with higher-risk profiles, resulting in expedited regulatory responses. The regulator also more frequently shares information with domestic and international securities and banking regulators, in particular with the Securities and Exchange Commission (SEC) and the Municipal Securities Rulemaking Board (MSRB).
In addition to several positive changes the regulator observed—improvement of new products review; better management of conflicts of interest; greater market transparency to retail investors—firms can find a number of lessons instructive.
Challenges in several areas contribute to occasional comprises in the quality of service that firms deliver to customers, and can contribute to compliance and supervisory breakdowns. First, firms should align their interests with those of its customers. Put customer interests first, the regulator emphasizes. Failing to do so is a central failing FINRA has observed. The harm this can cause can also be compounded when it involves vulnerable investors, such as senior investors, or a major liquidity or wealth event in an investor’s life: in other words, an inheritance or rollover of an individual retirement account (IRA).
Poor advice and investments in these situations can have especially devastating and lasting consequences for the investor. Irrespective of a firm’s need to meet a suitability or fiduciary standard, FINRA believes that firms best serve their customers—and reduce their regulatory risk—by putting customers’ interests first.
Take a close look at the culture of the firm, FINRA advises. The regulator says that many problems in financial services have roots in firm culture. A poor culture may stem from management’s undue emphasis on short-term profits or pursuit of rapid growth without a concurrent concern for controls, for example.
Boards of directors and senior executives must outline and adhere to high standards of ethical behavior that are expected and visible throughout the organization and are embedded in the firm’s incentives. These standards should come from the board and executives and not be viewed as a compliance task. The absence of stated standards can contribute to failures at the individual broker level (for example, disregard for customer needs in recommending securities) and can likewise bring about problems with potentially market-wide implications (e.g., manipulation of indices or the manufacture and marketing of unsuitable securities).
Firms must protect their culture against individual bad actors, as well as firm-wide behaviors that can gradually erode that culture. Firm policies should signify that poor practices, whatever the magnitude of the harm caused or potential implications, will not be tolerated.
FINRA also emphasized the need for a firm’s system of supervision, risk management and controls as essential safeguards to protect and reinforce a firm’s culture, and rigorous new-product reviews for product and service offerings.
Conflicts of interest continue as a contributing factor in many regulatory actions FINRA and other regulators have taken against firms and individuals. The regulator said it is reviewing situations where market access customers self-monitor and self-report suspicious trading despite an inherent conflict of interest. And it continues to focus on fee and compensation structures that lie at the heart of many conflicts and which can at times compromise the objectivity registered representatives provide to customers.
Priorities for 2015 focus on key sales practice, financial and operational and market integrity matters.
FINRA Will Be Watching
FINRA’s 2015 surveillance and examination activities that include product-related risk reviews will routinely focus on due diligence, suitability, disclosure, supervision and training. Product-focused concerns may include features of the product itself as well as sales or distribution practices. Some products are complex and may be subject to substantial market, credit, liquidity or operational risks. As always, firms and registered representatives should be attentive to changing circumstances—such as the precipitous fall in oil prices or the rapid fall in some emerging and frontier market indices—that may affect suitability decisions and risk descriptions. Training registered representatives about product features, pricing and valuation, and providing guidance around suitability are important steps in meeting these challenges.IRA Rollovers
A major area of focus is firms’ controls around the handling of IRA rollovers and other wealth events in investors’ lives. A broker’s recommendations made in connection with a wealth event can have long-lasting consequences for the customer. In 2015, examiners will focus on the controls firms have in place related to wealth events, with an emphasis on firms’ compliance with their supervisory, suitability and disclosure obligations. Firms’ systems should be reasonably designed to help ensure that financial incentives to the associated person or the firm do not compromise the objectivity of suitability reviews.
Part of FINRA’s focus will be IRAs, one of the principal vehicles Americans use to save for retirement. According to the Investment Company Institute, over one-quarter of Americans’ retirement savings are held in IRAs and this percentage is growing. Rollovers from employer plans—such as 401(k) plans—play an important role in funding these IRAs. FINRA has stated that, whether in retail communications or an oral marketing campaign, it would be false and misleading to imply that a retiree’s only choice, or only sound choice, is to roll over plan assets to an IRA sponsored by the broker/dealer.
Any communications that discuss IRA fees must be fair and balanced, and the broker/dealer may not claim that its IRAs are “free” or carry “no fee” when the investor will incur costs related to the account, account investments or both. If a broker/dealer does not intend for its registered representatives to recommend securities transactions as part of the IRA rollovers of their customers, then the broker/dealer should have policies, procedures, controls and training reasonably designed to ensure that no recommendation occurs. Similarly, if registered representatives are authorized to provide educational information only, a firm’s written supervisory procedures should be reasonably designed to ensure that recommendations are not made.
Without strong oversight, investors may not obtain the information necessary to make an informed decision, and firms may fail to detect recommendations otherwise prohibited by firm policy.
Interest Rate-Sensitive Fixed-Income Securities
FINRA’s 2014 Regulatory and Examination Priorities letter detailed concerns about the interest rate environment and the potential harm to customers holding interest rate-sensitive products that could result from shifts in that environment, and those concerns remain unchanged. FINRA also recognizes, however, that fixed-income products play an important role in a well-constructed portfolio.
What is critical is that firms’ communications discuss the impact of interest rate changes on price when marketing products that are interest rate-sensitive. In 2015, FINRA examiners will look for concentrated positions in products that are highly sensitive to interest rates—such as long-duration, fixed-income securities, high-yield bonds, mortgage-backed securities, or bond funds composed of interest rate-sensitive securities—and test for suitability and adequate disclosures. Examiners may also review firms’ efforts to educate registered representatives and customers about such products.
Assessments of compensation structures concerning variable annuities that might improperly be incentives to sell the products will be a key area of FINRA’s focus. Also under scrutiny will be the suitability of recommendations, statements made by registered representatives about these products, and the adequacy of disclosures made about features of variable annuities.
FINRA’s Annual Regulatory and Examination Priorities Letter can be downloaded from here.