What Firms Should Consider for a FINRA Exam to Run Smoothly
Open and regular communication. It is important for FINRA and for the firms to have ongoing dialogue throughout an examination process. It's a two-way street. FINRA wants to be transparent with firms and help them understand the focus of their exams. If a firm needs clarification or wants FINRA to expand on what it is that they’re trying to analyze, open dialogue can go a long way in assisting with that information being provided in a timely and efficient way. Also, at times when FINRA is making requests, if the firm is working through gathering that information and certain information becomes available sooner than other material, look for opportunities to provide that to FINRA sooner rather than later. Work with them to understand how to prioritize their requests. Part of that open communication, from FINRA's perspective, is sharing with firms the status of the exam.
How to Seek Clarity When FINRA Requests Feel Overly Broad in Connection with an Exam
Again, transparency and frequent communication are keys. Reach out proactively and explain what your firm has available. Have a conversation to determine the best road map to answer FINRA’s questions. Illustrate just how eager you are to come to an agreement that works for both sides. Ask if there’s a way that you can provide the information in a different format or if the staff really needs it in the specific prescribed form and format. Take the time to connect directly with FINRA. Ask for an in-person or Zoom meeting if possible, so there’s an open dialogue. Regular check-ins, depending on the exam, can be helpful as well. For example, you might request weekly check-ins to address where the firm is in the process, if FINRA is comfortable with the flow of information, and if certain things should be prioritized.
Make sure that your firm understands what the staff is asking for because there's nothing worse than thinking that you know and understand, and you go off and start gathering, and then, you produce it and learn that FINRA was expecting something else. The staff may be frustrated, and you have to start the work all over again.
Gain agreement on the terminology and what it means. For example, sometimes the terminology is close, but what a regulator is using to describe something and what the firm uses is slightly different. Make sure you are on the same page and that you are comparing apples to apples.
FINRA has resumed some on-site examinations where they feel that it's necessary, and there are certain unique circumstances that lead them to that conclusion. On the positive side, in some situations, on-site examinations can help build relationships and trust. Some smaller firms have been asking for on-site exams. FINRA’s decision whether to go on-site is premised on a risk-based approach depending on the nature of the firm, where it is risk ranked within FINRA, whether there's a history of difficulty in obtaining documents, along with several other factors that would lead FINRA to believe that going on-site is going to be more beneficial.
FINRA has been extremely cautious, in terms of COVID with its employees. Safety protocols will continue to be enforced. Be prepared to answer questions from examiners about the firm with respect to COVID and its policies and procedures, the space that will be offered to FINRA employees when they come, and so on.
Training New Examiners
Some firms have expressed concern about the expertise of junior examiners. FINRA has many new examiners including those who have never conducted an on-site exam due to COVID. FINRA is expecting to conduct more on-site training to help new personnel learns what the broker-dealer environment looks like at firms.
FINRA also has made changes to its organizational structure over the last two years to realign its staff with the business lines (firm groupings) of the firms that they examine. They have aligned examiners’ expertise and their primary responsibilities for executing exams with those firm groupings.
FINRA also has a program internally that leverages, what they refer to as, on-the-job trainers. They have specific individuals whose primary responsibility is to shadow and accompany a less experienced examiner to walk them through the steps that are necessary for executing reviews.
In addition, FINRA has kicked off a college of examinations program. This is a new program that FINRA started that's focused on entry-level candidates to participate in a six-week immersive training experience.
When Enforcement Is Brought into an Exam Situation
Nothing catches firms’ attention more than the presence of Enforcement personnel for an exam. There are various situations that could lead FINRA to decide that the Division of Enforcement should get involved in a particular stage of an exam. However, it is likely that Enforcement’s participation in cycle exams is going to decrease. Some at FINRA are in favor of bifurcating those issues—i.e., if a particular issue warrants referral to Enforcement, it will be split off from the exam. The difficulty of Enforcement participating in exams and conducting OTRs is it really expands the breadth and length of the exam often for a long time and FINRA may be unable to conclude the exam in the time they would prefer.
If Enforcement does appear during an exam, ask appropriate questions concerning the reason for their presence, be open, be transparent, and be as cooperative and helpful as possible. Provide the necessary information, clarify anything that might be creating challenge or confusion, and ensure that the exam can proceed productively.
Best Practices for Coordination among Regulators
Firms should not assume that FINRA and the SEC or other regulators are aware of the existence of the others' review or the details of the others' review and the extent to which they may overlap. Reach out and ask whether the regulator is aware of the other’s review and whether the firm can provide some information concerning such reviews. They often are willing to talk to each other, FINRA is in regular contact with the SEC, and, as much as FINRA tries to understand and communicate with the SEC as to when they may be going into a particular firm, there are situations where FINRA is not aware. So, bring it to FINRA’s attention. It is important to know, too, that the SEC cannot instruct FINRA to look at something or not look at something.
In addition, FINRA’s Office of Regulatory Liaison is a new unit that FINRA has created to deal with the relationship between FINRA and the SEC. The office helps coordinate these issues and oversight exams and acts as a liaison between the exam program and other parts of FINRA and the SEC to try to develop a proper level of coordination, so there's less duplication.
SEC's Regulation Best Interest (Reg BI)
Everyone in the industry is focused on Reg BI. FINRA regularly engages with the SEC concerning interpretations or guidance on SEC-specific regulations. The SEC's Regulation Best Interest (Reg BI) under the Securities Exchange Act of 1934 is a prime example. Reg BI establishes a "best interest" standard of conduct for broker-dealers and associated persons when they make a recommendation to a retail customer of any securities transaction or investment strategy involving securities, including recommendations of types of accounts.
As part of the rulemaking package, the SEC has adopted new rules and forms to require broker-dealers and investment advisers to provide a brief relationship summary, Form CRS, to retail investors. In addition, the SEC published interpretations concerning investment advisers’ standard of conduct under the Investment Advisers Act of 1940, and the "solely incidental" prong of the broker-dealer exclusion from the Advisers Act.
When there's a need for clarification or an interpretive question that might arise around how to apply certain aspects of Reg BI, FINRA engages with the SEC. FINRA wants to understand where the SEC might be doing some work and what the scope of that work is so FINRA can make determinations if it makes sense for them to do anything in that space, or if they should want to defer to the SEC.
Targeted Exam Letters, a.k.a. Sweeps
FINRA and other regulators conduct targeted exams, known as sweeps, to gather information that may lead to investigations. Sweep information is used to focus examinations and pinpoint regulatory responses to emerging issues. Sweeps are posted on FINRA's website and there were three announced in 2021, option account openings, social media influencers, and Special Purpose Acquisition Companies (SPACs).
The number of firms that are the subject of sweeps varies, and the firms that are included are carefully chosen based on a variety of factors, including level and nature of business activity in a particular area, customer complaints and regulatory history, and prior examination findings.
The issues evaluated in sweeps varies and can include documentation, compliance, adequacy of due diligence, supervision of specific transactions such as options trading, consistency of exceptions, the quality of a firm’s written procedures, and more.
Consolidated Audit Trail (CAT)
SEC Rule 613 requires FINRA and the national securities exchanges to jointly submit a National Market System (NMS) plan detailing how they would develop, implement and maintain a consolidated audit trail that collects and accurately identifies every order, cancellation, modification and trade execution for all exchange-listed equities and options across all U.S. markets.
CAT is a hot topic with FINRA. Early observations involve the reporting of data or the failure to report certain information. FINRA has seen where firms have either failed to report required information or misreported, issues involving the underlying feeds and how they're preparing that information and reporting it into CAT in a manner that is inaccurate or incomplete. Certain transactions may be omitted. And what's important for firms to understand is how those records are compiled to be reported. Often, it is information that's coming from a firm's system that then must be put in a format so that it can be reported. It’s important for firms to understand how that process works and where there might be risk that information might be omitted or transmitted in a format that isn't compliant.
FINRA’s Hot-Buttons List for 2022
The FINRA panelists also discussed their hot-button issues for 2022 which broker-dealers and legal counsel should keep an eye on. They include:
- Complex products sold to retail customers
- Reg BI considerations involving complex products
- The use of non-firm systems to communicate
- Outside business activities (OBAs)
- Private securities transactions (PSTs)
- Broker-dealer training for registered reps, supervisory personnel, compliance and others
- Vendor management and due diligence