FINRA Podcast: 2014 Regulatory and Examination Priorities - Part 4: Fraud Prevention and Financial and Operational Priorities (with Lofchie Comment)

FINRA released the fourth podcast in its five-part series providing an overview of FINRA's 2014 examination priorities. The primary focus of the fourth podcast is fraud prevention and financial and operational priorities. Specifically, it addresses areas of fraud prevention, including:

• Microcap Fraud: FINRA found that speculative microcap and low-priced over-the-counter ("OTC") securities are an area of significant ongoing concern. FINRA recommended that firms should review their policies and procedures to ensure that activities related to microcap and low-priced OTC securities are compliant with FINRA rules and federal securities laws. Furthermore, firms should perform heightened supervision of employees who maintain direct or indirect outside-business activities associated with microcap and OTC companies, traders involved in trading microcap and low-priced OTC securities, and firm activities in which an affiliate of the firm is the transfer agent for the microcap or low-priced OTC securities.
• Insider Trading: Insider trading continues to be a top regulatory priority for FINRA and the other financial regulators. FINRA recommended that firms should routinely review the electronic communications of personnel with business units that may come into possession of material, nonpublic information during the normal course of business. Furthermore, FINRA stated, it expects firms to monitor employee trading activity, both inside and outside the firms, to identify suspicious activity and to conduct regular reviews of proprietary and customer trading in securities that are placed on a watch/restricted list.

FINRA also addressed financial and operational priorities, including the following:

• Funding and Liquidity Risk: FINRA stated that it will undertake a more structured review of this area in order to compare strengths and weaknesses across firms and identify effective practices. FINRA expressed concern about the heightened potential for collateral squeezes and the adverse impact these may have on firms' ability to fund their operations. The increased use of CCPs and cleared swaps is boosting the demand for high-quality collateral. FINRA noted that meeting this demand may prove challenging and raise the cost of certain traditional channels for obtaining such collateral.
• Risk Control Documentation Assessment: FINRA stated that it will examine risk controls in 2014 to understand whether such documentation is both reflective of the controls in place and reasonably designed to mitigate credit, market and liquidity risks.
• Accuracy of Firm's Financial Statements and Net Capital: FINRA recommended that firms review the manner in which they maintain their books and records, and ensure that the firms have the proper expertise (employee(s) or on or off-site financial and operations principals) to maintain books and records that are accurate and prepared in accordance with U.S. Generally Accepted Accounting Principles ("GAAP"). FINRA found that areas of continued concern include the following:
  • failure to apply Open Contractual Commitment Charges, haircuts, undue concentration or blockage charges;
  • failure to comply with the Net Capital Rule at all times and, as a related item, to cease operations when a firm is under capital until the net capital deficiency is cured;
  • failure to prepare books and records on an accrual basis, or to do more than make proper accruals at the end of a broker-dealer's fiscal year; and
  • netting transactions in the absence of authoritative accounting guidance that permits such netting.

Lofchie Comment: There is as yet no real body of law on liquidity requirements, so each firm must be prepared to defend the approach that it takes on the issue. The netting and documentation issues are ones to which broker-dealers must pay more attention. Historically, banks have had to question whether their various obligations could be netted and obtain opinions in that regard; now broker-dealers will have to do so as well. While some of the issues are straightforward, lots of difficult questions arise, even on plain-vanilla transactions, when a broker-dealer is transacting with a non-U.S. entity that is not subject to the U.S. Bankruptcy Code, or with various types of U.S. entities that are likewise not subject to the Code and whose insolvency will be governed by state law; e.g., insurance companies. In any case, broker-dealer FinOps should undertake a systematic review of circumstances in which they are netting obligations and consider whether such netting is appropriate, and whether supporting documentation (such as additional representations or legal opinions) are needed to justify the netting.

See: FINRA Podcast.Related news: FINRA Podcast: 2014 Regulatory and Examination Priorities - Part 3: Business Conduct Concerns (April 8, 2014);FINRA Podcast: 2014 Regulatory and Examination Priorities - Part 2: Recidivists, Conflicts, Cybersecurity, Rollovers and Accredited Investors (March 24, 2014); FINRA Podcast: 2014 Regulatory and Examination Priorities - Part 1: Suitability (with Lofchie Comment) (March 14, 2014).