common examination findings and compliance …...common examination findings and compliance...

© 2018 Financial Industry Regulatory Authority, Inc. All rights reserved. 1

Common Examination Findings and Compliance Effective Practices (Medium/Large Firm Focus) Tuesday, May 22 11:15 a.m. – 12:15 p.m.

Join FINRA staff as they discuss the most common deficiencies noted during FINRA cycle examinations of medium and large firms. Industry practitioners discuss effective practices for preparing for examinations, taking corrective action, and updating compliance procedures and practices based on examination results.

Moderator: Michael Solomon Senior Vice President and Senior Regional Director FINRA Northeast Region

Panelists: Kristen Dugan Managing Director and Compliance Executive Bank of America

Scott Gilbert Senior Director, Sales Practice FINRA New York District Office

Rocco Procopio Executive Director Morgan Stanley Wealth Management


Common Examination Findings and Compliance Effective Practices (Medium/Large Firm Focus) Panelist Bios: Moderator: Michael Solomon joined FINRA in December 2011 as senior vice president and is the senior regional director of FINRA's New York, Philadelphia, Boston, and Woodbridge-NJ District Offices. Mr. Solomon has responsibility for the Examination and Surveillance Programs in the region. Prior to FINRA he served as managing director and general counsel for litigation, regulatory and employment law at Jefferies & Co. Prior to joining Jefferies, Mr. Solomon managed the Regulatory Group at UBS Financial Services from 2004 to 2006. Before that, he managed the Regulatory Examinations and Inquiries Group at Merrill Lynch from 1999 to 2004, and has also served as an associate at Morgan, Lewis & Bockius, trial counsel in the NYSE Enforcement Division and NY County assistant district attorney. Mr. Solomon received his J.D. in 1989 from New York University School of Law and received an undergraduate degree from Wesleyan University. Panelists: Kristen Dugan, Managing Director and Compliance Executive at Bank of America, is responsible for compliance oversight of client-facing business activities and supervision for the Merrill Lynch Wealth Management and Merrill Edge businesses. She also leads Compliance teams responsible for coverage of operations and banking products offered to wealth management clients and the resolution and reporting of broker dealer customer complaints. In these roles, Ms. Dugan oversees activities relating to monitoring, testing, policies and risk assessments. Her experience includes securities and consumer banking laws as well as anti-money laundering regulations. Ms. Dugan’s tenure at the organization began at Merrill Lynch and she has been with the company for more than 20 years, holding various positions within Corporate Audit and the Defined Asset Funds product area. While in Corporate Audit, she led the team responsible for audit coverage of the Wealth & Investment Management organization, as well as certain enterprise-wide audit functions. Ms. Dugan and her team were responsible for providing an independent assessment of internal business controls and processes and making recommendations in support of the company’s risk framework and business strategies. Ms. Dugan also served several years on the Bank’s Global Diversity & Inclusion Council. Prior to joining Merrill Lynch, she worked at KPMG and was responsible for financial statement audits for various financial institutions. Ms. Dugan holds a bachelor’s degree in accounting from Rider University, is a Certified Public Accountant and holds the FINRA series 24 license. Scott M. Gilbert is Senior Director with FINRA with responsibility for the New York District’s large firm sales practice examination program and the District’s cause examination program. From 2004 through 2013, Mr. Gilbert was employed at UBS Financial Services Inc. in various roles including Executive Director and Head of Compliance for the Wealth Management Advisor Group of UBS, with responsibility for compliance matters and policies relating to the broker-dealer’s financial advisors. From 2006 through 2010, he was Senior Associate General Counsel and head of the group responsible for internal investigations and disciplinary recommendations at UBS. In that role, he advised the firm's management in all aspects of issues related to employee compliance with firm policies and industry rules, regulations and laws. From 2000 to 2004, Mr. Gilbert was Vice President and Senior Counsel with Merrill Lynch & Co., where he was responsible for global regulatory matters and internal investigations. Before that, he was a trial counsel with the Division of Enforcement of the New York Stock Exchange, responsible for enforcing the rules of that self-regulatory organization, investigating customer complaints and prosecuting disciplinary actions. He also was previously a litigation attorney in private practice, with a focus on complex commercial litigation and securities class actions. Mr. Gilbert is a graduate of Columbia University and New York University School of Law. Rocky Procopio is Executive Director with 20 years of financial industry experience. He is currently the head of Morgan Stanley Wealth Management’s Field Compliance Department. In this capacity, he oversees Regional Compliance Officer Department, WM Employee Trading, International Wealth Management Compliance and the Registration Department. Prior to the Morgan Stanley/Smith Barney joint venture, Mr. Procopio was responsible for the Surveillance and Training functions at Smith Barney. Prior to Smith Barney’s acquisition of Legg Mason Wood Walker (LMWW), he was a senior compliance


officer with LMWW responsible for the Mid-Atlantic Region as well as product compliance for the firm. Mr. Procopio currently holds the Series 7, 9, 10, 14, 24, 4, and 53.

2018 FINRA Annual ConferenceMay 21 – 23, 2018 • Washington, DC

Common Examination Findings and

Compliance Effective Practices

(Medium/Large Firm Focus)

FINRA Annual Conference | © 2018 FINRA. All rights reserved.

Moderator

Michael Solomon, Senior Vice President and Senior Regional Director, FINRA Northeast Region

Panelists

Kristen Dugan, Managing Director and Compliance Executive, Bank of America

Scott Gilbert, Senior Director, Sales Practice, FINRA New York District Office

Rocco Procopio, Executive Director, Morgan Stanley Wealth Management

Panelists

1

2018 Annual Regulatory and Examination Priorities Letter

IntroductionThe 2018 Regulatory and Examination Priorities Letter identifies topics that FINRA will focus on in the coming year, and these include some new topics as well as others that remain ongoing areas of focus. FINRA’s 2017 Examination Findings Report presents observations on both concerns and effective practices relevant to some of these areas, and FINRA encourages broker-dealers to use that report and this letter as resources to enhance their compliance, supervisory and risk management programs, and to prepare for their FINRA examination.

FraudFraud is always a major area of focus for FINRA. Fraudulent activities such as insider trading, microcap pump-and-dump schemes, issuer fraud and Ponzi-type schemes harm investors and damage the integrity of the market. In the past year, FINRA has made hundreds of referrals to the U.S. Securities and Exchange Commission (SEC) for potential insider trading and other fraudulent activities involving individuals or entities outside FINRA’s jurisdiction, and we will continue to pursue our investigations in these areas aggressively.

In addition, FINRA will focus on microcap fraud schemes, including schemes that target senior investors. FINRA investigations have identified senior investors who have been victimized by unregistered individuals using high-pressure sales tactics as part of a pump-and-dump scheme. Last year’s Regulatory and Examination Priorities Letter described controls firms can use to protect elderly investors, and, with the addition of FINRA’s new Rule 2165 and amendments to FINRA Rule 4512 (discussed later in this document), firms have even more tools to protect senior investors from these types of schemes. In addition, FINRA reminds firms of their obligation to file a Suspicious Activity Report (SAR) for illicit activity involving the exploitation of senior investors.1

Firms should be attentive to their brokers’ activity in microcap stocks, particularly when brokers show a new or sudden interest in buying microcap stocks for their own accounts or those of their customers. FINRA will investigate brokers who use their own or their customers’ accounts to coordinate trading in microcap stocks with known or unknown counterparties. Firms should also evaluate internal policies and training regarding permissible communications and interactions with microcap stock promoters to assist in preventing brokers from participating in any fraudulent scheme.

●● High-risk Firmsand Brokers 2

●● Operational andFinancial Risks 2

●● Sales Practice Risks 4

●● Market Integrity 6

●● New Rules 9

●● Conclusion 10

●● Endnotes 11

January 2018

Topics

http://www.finra.org/industry/2017-report-exam-findings

http://www.finra.org/industry/2017-report-exam-findings

22018 Regulatory and Examination Priorities Letter

High-risk Firms and BrokersBuilding on our work in 2017, a top priority for FINRA will continue to be identifying high-risk firms and individual brokers and mitigating the potential risks that they can pose to investors.2 FINRA will focus on firms’ hiring and supervisory practices for high-risk brokers, including, for example, firms’ remote supervision arrangements; supervision of point-of-sale activities, including individual broker accountability when using joint rep codes; and branch inspection programs. FINRA reminds firms of their existing obligation to adopt and implement tailored heightened supervisory procedures under FINRA Rule 3110 (Supervision) for high-risk individuals.

FINRA will also continue to focus on the risks that these firms and brokers pose to investors, including unsophisticated or senior investors. For example, we will focus on recommendations for speculative or complex products by high-risk brokers to investors who may not have the necessary sophistication, experience or investment objectives. We will also review situations where registered representatives have control of investors’ finances as power-of-attorney or trustee on customer accounts, or have future rights to customer assets as a named beneficiary on customer accounts. We will also evaluate rollovers of qualified plans into non-qualified accounts for senior investors.

In addition, FINRA will continue to focus on registered representatives who conduct approved private securities transactions by raising funds from investors they serve away from their firm. FINRA will assess firms’ ability to monitor the proper use of proceeds from these offerings and whether registered representatives make adequate disclosures about their interest in, control of, or association with the issuer.

FINRA will also continue to review firms’ controls regarding the outside business activities of registered persons, including to identify instances of settling away where registered representatives borrow money from their customers or make payments to customers from their outside business bank accounts.3

Operational and Financial RisksBusiness Continuity Planning

Recent events such as Hurricanes Harvey and Maria underscore the need for firms to maintain written Business Continuity Plans (BCPs) that address continued access to critical systems, including in situations where firms may not have physical access to locations, potentially for an extended period. FINRA Rule 4370 requires firms to maintain plans that are reasonably designed to enable them to meet their existing obligations to customers in an emergency or business disruption. FINRA will review firms’ BCPs with a focus on their implementation of the plan. For example, we will review how and under what circumstances firms activate their BCPs, how they classify systems as mission-critical or secondary, how they accomplish data backup and recovery, and where applicable, how firms coordinate with their affiliates and vendors during a business continuity situation. We will also review firms’ plans for restoring systems, procedures and records once they are prepared to return to normal business, as well as how they make those decisions.


Customer Protection and Verification of Assets and Liabilities

The protection of customer assets and the accuracy of firms’ financial data are perennial priorities in FINRA’s examinations. FINRA will examine the accuracy of firms’ net capital and reserve computations under Securities Exchange Act (SEA) Rules 15c3-1 and 15c3-3. In our examination of firms’ records, we will review their processes for verifying customer assets and proprietary assets and liabilities in those financial records. We may also contact appropriate entities, such as custodial banks, to assess the validity of reported positions.

In our examination of firms’ compliance with SEA Rule 15c3-3, we will evaluate whether firms have implemented adequate controls and supervision to protect customer assets and assess their compliance with the specific requirements of the rule (e.g., whether they properly perform their possession or control calculations). In addition, FINRA will review whether firms maintain sufficient documentation to demonstrate that securities are held free of liens and encumbrances, especially for securities held at foreign custodians. FINRA will review whether firms’ foreign depositories, clearing agencies and custodial banks are good control locations, including whether firms have filed applications with the SEC for such foreign custodial arrangements. We may also look at the underlying arrangements with foreign custodians to determine if they permit cross-liens or use temporary holding accounts. Where customer securities may be held in, or move through, temporary holding accounts, we will consider whether these accounts are good control locations and whether firms have instituted reasonable procedures to monitor them for customer securities.

Technology Governance

FINRA will review firms’ information and technology change management policies and procedures. Some firms have experienced significant customer service and regulatory problems as a result of operational breakdowns caused by the implementation of new systems as well as enhancements and modifications to existing proprietary or vendor systems. These breakdowns can arise from coding issues, system capacity limitations or other flaws, and may have a significant adverse impact on order entry or execution, data integrity or customer protection. It is critical that firms maintain strong controls over changes to their information technology to prevent inaccurate, incomplete, untested or unauthorized changes to their production environments. These can result in system defects or outages, data inaccuracies or unintended consequences that can negatively affect customers, the firm or the market.

Cybersecurity

Cybersecurity threats remain a significant risk and will continue to be a priority. FINRA will evaluate the effectiveness of firms’ cybersecurity programs to protect sensitive information, including personally identifiable information, from both external and internal threats. FINRA will review firms’ preparedness, technical defenses and resiliency measures, among other things. Firms should review the Examination Findings Report for additional information about FINRA’s observations regarding concerns and effective practices related to cybersecurity. FINRA also reminds firms that they must have policies and procedures in place to assess whether to file a SAR when they identify a cybersecurity event.


Anti-Money Laundering

FINRA will assess the adequacy of firms’ anti-money laundering (AML) programs. FINRA continues to identify concerns related to, for example, the adequacy of (1) firms’ policies and procedures to detect and report suspicious transactions; (2) resources for AML monitoring; and (3) independent testing required under FINRA Rule 3310(c). Firms should review the Examination Findings Report to understand FINRA’s areas of concern and observations on effective practices related to AML. In addition to those concerns, firms should be attentive to the potential use of their foreign affiliates to conduct high-risk transactions through accounts at member firms, including in microcap and dual-currency securities. FINRA has observed situations where firms do not monitor, or may monitor less closely, accounts opened for an affiliate. Firms should also confirm that their AML surveillance programs cover accounts used in connection with securities-backed lines of credit (SBLOCs) and aggregate activity across accounts when they use multiple accounts to receive and disburse funds in connection with an SBLOC.

Liquidity Risk

FINRA will continue to focus on firms’ liquidity planning, compare strengths and weaknesses across firms’ liquidity plans and share effective practices. FINRA will evaluate whether a firm’s liquidity planning is appropriate for the firm’s business and customers, and whether it includes scenarios that are consistent with its collateral resources and client activity. In addition, FINRA will focus on the adequacy of firms’ material stress testing assumptions, including how firms identify unencumbered assets and encumbered cash in their liquidity stress tests. A stress test that clearly identifies the largest liquidity sources and uses can enhance a firm’s liquidity planning. FINRA urges firms to review Regulatory Notice 15-33 for effective practices that may be useful in developing liquidity management plans.

Short Sales

FINRA will examine firms’ policies and procedures for establishing and monitoring the rates charged to customers for short sales. FINRA has observed some instances where, for example, securities are borrowed into a conduit account and then loaned to a house account at a significantly higher rate, which then may be marked up further. FINRA will review whether firms calculate such rates in a manner consistent with their procedures.

Sales Practice RisksSuitability

As the number and complexity of products available to investors continue to increase, FINRA will continue to assess the adequacy of firms’ controls to meet their suitability obligations. This includes reviewing how firms identify products that are subject to new product vetting, the vetting process itself, and the supervisory systems and controls firms put in place to ensure personnel are appropriately educated and trained on the sale and supervision of the product and that recommendations are suitable.4 As part of the vetting process, firms should identify the risks associated with a product and include those risks in their product training so that registered representatives can appropriately evaluate them prior to recommending the product to a customer. FINRA will pay particular attention to suitability determinations in those situations where registered representatives recommend complex products to unsophisticated, vulnerable investors.

http://www.finra.org/industry/notices/15-33


FINRA will review firms’ handling of products where FINRA has observed firms experiencing problems implementing effective controls, such as firms’ handling of Unit Investment Trusts (UITs) and multi-share class products as addressed in the Examination Findings Report, or products that are higher risk or complex. Moreover, FINRA will review for recommendations that result in undue concentration in securities positions, including recommendations resulting in concentrated positions in interest-rate-sensitive instruments or recommendations that result in short-term trading of products typically intended to be held on a long-term basis.

Employer-sponsored retirement plans play a critical role in many individuals’ retirement planning and for this reason will be an important area of focus for FINRA. In this regard, FINRA will focus on the suitability of firms’ and registered representatives’ recommendations made to plan participants, including Individual Retirement Account rollover recommendations involving securities transactions.5 FINRA will also review the supervisory mechanisms firms establish for these recommendations.

In addition, FINRA will review situations in which registered representatives recommend a switch from a brokerage account to an investment adviser account where that switch clearly disadvantages the customer, such as where the registered representative recommended that the customer purchase a securities product subject to a front-end sales charge in a brokerage account and then shortly thereafter recommended that account be transferred to a fee-based account.

Initial Coin Offerings and Cryptocurrencies

Digital assets (such as cryptocurrencies) and initial coin offerings (ICOs) have received significant media, public and regulatory attention in the past year.6 FINRA will closely monitor developments in this area, including the role firms and registered representatives may play in effecting transactions in such assets and ICOs. Where such assets are securities or where an ICO involves the offer and sale of securities, FINRA may review the mechanisms—for example, supervisory, compliance and operational infrastructure—firms have put in place to ensure compliance with relevant federal securities laws and regulations and FINRA rules.

Use of Margin

FINRA will assess firms’ disclosure and supervisory practices related to margin loans. FINRA has observed situations where registered representatives solicited customers to engage in share purchases on margin, but customers were not aware of the risks associated with those transactions. Moreover, in some cases, registered representatives entered into margin transactions without written authority from the customer. FINRA will examine whether firms and registered representatives adequately disclose the risk of margin loans and whether firms maintain controls reasonably designed to prevent excessive margin trading.


Securities Backed Lines of Credit

The use of SBLOCs has increased significantly in the past years, and FINRA will review firms’ compliance with sales practice and operational obligations that apply to SBLOCs. FINRA will assess the adequacy of disclosures firms provide customers regarding the potential risks associated with SBLOCs, including the potential impact of a market downturn, the potential tax implications if pledged securities are liquidated and the potential impact of an increase in interest rates.

Separately, where the SBLOC lender is an affiliate of the member firm or other third party, the firm must establish controls to earmark the collateral securing the SBLOC and ensure that the SBLOC collateral is not dually pledged for any other extension of credit (e.g., a margin arrangement with the firm). In these cases, firms must also be alert to red flags indicating that proceeds of an SBLOC are possibly being used to purchase or carry margin stock and follow-up to ensure that they are not improperly arranging credit.

Market IntegrityManipulation

Protecting the integrity of our markets must remain a top priority for firms, as it is for FINRA. To capture new threat scenarios and changes in market participants’ behavior, we regularly evaluate our surveillance program, and enhance and expand it to address these changes, and firms should be aware that FINRA may review their programs in these areas. For example, we launched the Cross Market Auction Ramping surveillance pattern in August 2017. This pattern leverages machine learning techniques to identify aggressive and dominant trading surrounding the open or close. We also (1) revised our Cross Market Marking the Open and Close surveillance pattern to reduce false positives and more accurately identify potential instances of marking the open or close and (2) enhanced the Cross Market Layering surveillance pattern in July 2017 to detect collusion among multiple market participants engaged in layering. In addition, we are working on incorporating machine learning techniques to aid in further detection of manipulative layering activity.

Best Execution

Best execution is an important investor protection requirement and remains a FINRA priority. In addition to the concerns identified in the Examination Findings Report, FINRA is expanding our equity best execution surveillance program to assess the degree to which firms provide price improvement when routing customer orders for execution or when executing internalized customer orders. Once the new surveillance pattern is in production, we will review systematically both the frequency of price improvement, as well as the relative amount of price improvement obtained or provided when compared to other routing or execution venues.7

In addition, FINRA initiated an examination sweep in November 2017 that focuses on broker-dealers’ best execution obligations when they receive order routing inducements, such as payment for order flow and maker-taker rebates, or when they internalize order flow. If a broker-dealer receives an order routing inducement, it must not let that inducement or its proprietary interests interfere with its duty of best execution. FINRA


will review how broker-dealers manage the conflict of interest that exists between their duty of best execution and their own financial interests, including whether the broker-dealers’ procedures provide for a regular and rigorous evaluation of the execution quality they are likely to obtain from the market centers trading a security.

We will also expand our review of execution quality and fair pricing in fixed income securities. For example, we expect to implement surveillance patterns that focus on fair pricing and best execution in transactions in Treasury securities.

Regulation SHO

FINRA will increase our focus on evaluating firms’ compliance with Rule 201 of Regulation SHO. That rule requires firms to develop policies and procedures to prevent the execution or display of a short sale order at a price that is equal to or less than the national best bid when a Short Sale Circuit Breaker (SSCB) is in effect for a National Market System (NMS) security.8 If a firm’s Rule 201 policies and procedures include an automated, rules-based control to ensure compliance, FINRA expects the firm to develop a supervisory system to test that the control works properly and to conduct thorough supervisory reviews both before and regularly after it is operational.

If a firm chooses to rely on an exemption to Rule 201, it must ensure that its activity or short sale transactions qualify for the exemption. For example, FINRA has observed that firms engaging in exchange-traded fund arbitrage activity are availing themselves of the Domestic Arbitrage Exemption detailed in Rule 201(d)(3), although SEC written guidance states that (1) the exemption does not apply to such activity and (2) a “bona fide market making” exemption to Rule 201 does not exist. Finally, firms that choose to execute a short sale in reliance on an exemption to Rule 201 must mark the order and report the trade as short exempt.

Fixed Income Data Integrity

Data integrity remains a priority for FINRA’s fixed income surveillance and trading examination programs. In anticipation of the launch of Treasury securities reporting to the Trade Reporting and Compliance Engine (TRACE) in July 2017, FINRA developed a suite of data integrity surveillance patterns to monitor firms’ transaction reporting in Treasury securities. The patterns identify instances of late reporting, failing to report inter-dealer trades, misreporting of inter-dealer trades and inaccurate execution time reporting, and we remain focused on these issues in 2018.

In addition, FINRA will expand our examinations to include Treasury securities in our reviews for complete, timely and accurate reporting of TRACE-eligible securities. A crucial aspect of these reviews involves electronic communications with customers and potential discrepancies in the transaction information contained in the electronic communications compared to the firms’ records or reports to TRACE.


Options

FINRA developed a surveillance pattern to detect potential front running in correlated options products in 2017 and will remain focused on this area in 2018. We designed the surveillance pattern to detect related scenarios involving options where a market participant may engage in transactions in one product while having knowledge of a pending transaction in a correlated product prior to the public dissemination of the terms of the order. This activity may improperly benefit the participant that engaged in the front running activity, to the potential detriment of other market participants.

FINRA will also focus on options “marking the close” activity where orders are being sent immediately prior to the close that impact the final national best bid or offer (NBBO) to benefit positions held by that account or accounts with which they are acting in concert. FINRA has identified a number of firms with deficient or non-existent supervisory systems relating to “marking the close” activity.

FINRA will continue to conduct reviews of potential options-related violations of SEA Rule 14e-4, which governs partial tender offers and requires that participants tender no greater than their “net long position.” SEA Rule 14e-4 provides that if a market participant sells call options after the tender offer is announced with a strike price less than the tender offer price, it must reduce its long position by the shares underlying the options for purposes of calculating its net long position. Those tendering in excess of their net long position by not offsetting the options may improperly receive a greater share of the tender offer consideration, to the detriment of other market participants. During 2017, FINRA identified participants who have not properly accounted for their options positions when tendering shares in the offer.

Market Access

FINRA will continue to review broker-dealers’ compliance with SEA Rule 15c3-5 (the Market Access Rule). The Market Access Rule requires that broker-dealers establish reasonable pre-trade financial controls, among other things. FINRA has seen instances where broker-dealers have not maintained reasonable documentation to support financial limits and have not conducted periodic reviews to assess the reasonableness of those thresholds (through a credit or capital utilization review, for example). Firms should review the Examination Findings Report for additional information about FINRA’s observations regarding concerns and effective practices related to market access.

Alternative Trading System Surveillance

As registered broker-dealers and FINRA members, alternative trading systems are required to maintain supervisory systems that are reasonably designed to achieve compliance with applicable securities laws, regulations and FINRA rules, including, for example, rules on disruptive or manipulative quoting and trading activity. FINRA will review alternative trading systems’ supervisory systems in the context of reviews opened as a result of surveillance alerts related to potential manipulative activity occurring on or through an alternative trading system.


Report Cards

In 2018, FINRA will launch several new report cards to assist firms with their compliance efforts, and we will review whether and how firms make use of these report cards.

XX The Auto Execution Manipulation Report Card will highlight and assist firms with their supervision efforts to identify instances in which a market participant uses non-bona fide orders to move the NBBO.

XX The Alternative Trading System Cross Manipulation Report Card will identify instances in which a market participant engages in potential manipulation of the NBBO, which results in the modification of a security’s prevailing midpoint price on an alternative trading system crossing venue.

XX The Fixed Income Mark-up Report Card will provide information to firms—including median and mean percentage mark-ups for each firm—and the industry, which firms will be able to display based on certain criteria such as investment rating, product (e.g., corporate or agency) and length of time to maturity. FINRA will consider adding additional products in the future.

New RulesFINRA draws firms’ attention to some significant new rules that are currently scheduled to become applicable in 2018. FINRA may discuss with some firms the steps they are taking to implement the obligations under these rules.

XX Financial Exploitation of Specified Adults: FINRA Rule 2165 will become effective February 5, 2018, and permits members to place temporary holds on disbursements of funds or securities from the accounts of specified customers where there is a reasonable belief of financial exploitation of these customers.

XX Amendments to FINRA Rule 4512 (Customer Account Information): An amendment to FINRA Rule 4512 requires members to make reasonable efforts to obtain the name of and contact information for a trusted contact person for a non-institutional customer’s account. The amendment will become effective February 5, 2018.

XX The Financial Crimes Enforcement Network’s (FinCEN) Customer Due Diligence Rule (CDD Rule): Firms have until May 11, 2018, to comply with FinCEN’s CDD Rule.9 FinCEN issued the CDD Rule to clarify and strengthen customer due diligence for covered financial institutions, including broker-dealers. In the CDD Rule, FinCEN identifies four components of customer due diligence: (1) customer identification and verification; (2) beneficial ownership identification and verification; (3) understanding the nature and purpose of customer relationships; and (4) ongoing monitoring for reporting suspicious transactions and, on a risk basis, maintaining and updating customer information.10

XX Amendments to FINRA Rule 2232 (Customer Confirmations): The amended FINRA Rule 2232 requires a member to disclose the amount of mark-up or mark-down it applies to trades with retail customers in corporate or agency debt securities if the member also executes offsetting principal trades in the same security on the same trading day. The amended rule also requires members to disclose two additional items on all retail customer confirmations for corporate and agency debt security trades: (1) a reference,


and a hyperlink if the confirmation is electronic, to a web page hosted by FINRA that contains publicly available trading data for the specific security that was traded and (2) the execution time of the transaction, expressed to the second. These amendments are scheduled to become effective on May 14, 2018.

XX Margin Requirements for Covered Agency Transactions (Amendments to FINRA Rule 4210):11 FINRA’s new margin requirements for Covered Agency Transactions are scheduled to become effective on June 25, 2018. Covered Agency Transactions include (1) To Be Announced (TBA) transactions, inclusive of adjustable rate mortgage (ARM) transactions; (2) Specified Pool Transactions; and (3) transactions in Collateralized Mortgage Obligations (CMOs), issued in conformity with a program of an agency or Government-Sponsored Enterprise (GSE), with forward settlement dates. Members are reminded that the risk limit determination requirements under the amendments to Rule 4210 became effective on December 15, 2016.

XX Consolidated FINRA Registration Rules: The consolidated FINRA registration rules (FINRA Rules 1210 through 1240) will become effective October 1, 2018. The consolidated rules streamline, and bring consistency and uniformity to, the qualification and registration requirements. Among other things, FINRA has restructured the representative-level qualification examination program into a more efficient format whereby all representative-level applicants will take a general knowledge examination and a tailored, specialized knowledge examination (a revised representative-level qualification examination) for their particular registered role. Individuals who are not associated persons of firms, such as members of the general public, are also eligible to take the Securities Industry Essentials Exam. The restructured program, among other things, eliminates duplicative testing of general securities knowledge on representative-level examinations and eliminates several representative-level registration categories that have become outdated or have limited utility.

ConclusionThis letter outlines FINRA’s areas of focus as of the beginning of 2018, and FINRA urges firms to use it as a point of reference for their compliance, supervisory and risk management programs and to prepare for FINRA examinations. FINRA may adjust its priorities as circumstances change. As always, we urge you to contact your firm’s FINRA regulatory coordinator with specific questions or comments. In addition, if you have general comments regarding this letter or suggestions on how we can improve it, please send them to Steven Polansky, Senior Director, Regulatory Operations/Shared Services, at [email protected].


Endnotes1 See FinCEN Advisory.

2 See “Protecting Investors From Bad Actors,” Robert W. Cook, President and CEO, FINRA, at the McDonough School of Business, Georgetown University, June 12, 2017.

3 Following a FINRA360 retrospective review of rules regarding registered representatives’ outside business activities and private securities transactions, FINRA’s Board of Governors approved the publication of a Regulatory Notice seeking comment on a proposal that would reduce unnecessary burdens while maintaining strong investor protections.

4 See Regulatory Notices 03-71, 05-26, 05-59, 09-31, 09-73, 10-09, 11-02, 11-25, 12-03, 12-25, 12-55 and 13-31.

5 See Regulatory Notice 13-45.

6 See FINRA Investor Alerts Don’t Fall for Cryptocurrency-Related Stock Scams, December 21, 2017, and Initial Coin Offerings: Know Before You Invest, August 31, 2017.

7 In November 2015, FINRA issued Regulatory Notice 15-46, which reiterated that simply obtaining the best bid or best offer may not satisfy a firm’s best execution obligation when routing order flow for automated execution, or internally executing such order flow, particularly for small orders.

8 A 10 percent or more decrease in the price of a security from its closing price on the prior day triggers an SSCB.

9 See FinCEN Customer Due Diligence Requirements for Financial Institutions, 81 FR 29397 (May 11, 2016).

10 See Regulatory Notice 17-40.

11 See Regulatory Notice 16-31 (announcing the SEC’s approval of amendments to FINRA Rule 4210 to establish margin requirements for Covered Agency Transactions) and Regulatory Notice 17-28 (extending the effective date of the new margin requirements to June 25, 2018, and announcing the availability of a set of frequently asked questions and guidance to assist members in complying with the new requirements).

https://www.fincen.gov/resources/advisories/fincen-advisory-fin-2011-a003

http://www.finra.org/newsroom/speeches/061217-protecting-investors-bad-actors














https://www.finra.org/investors/alerts/dont-fall-cryptocurrency-related-stock-scams

https://www.finra.org/investors/alerts/dont-fall-cryptocurrency-related-stock-scams


https://www.federalregister.gov/documents/2016/05/11/2016-10567/customer-due-diligence-requirements-for-financial-institutions




Report on FINRA Examination Findings | December 20171

CONTENTS

Highlighted Observations 2

Cybersecurity 2

OutsideBusinessActivitiesandPrivateSecuritiesTransactions 4

Anti-MoneyLaunderingComplianceProgram 5

ProductSuitability 6

BestExecution 8

MarketAccessControls 9

Summary of Additional Observations 11

AlternativeInvestmentsHeldinIndividualRetirementAccounts(IRAs) 11

NetCapitalandCreditRiskAssessments 11

OrderCapacity 12

RegulationSHO 13

TRACEReporting 13

DECEMBER 2017

FINRA’s examination program plays a central role in supporting FINRA’s mission of investor protection and market integrity. A main component of this program is FINRA’s examinations of broker-dealers (“firms” or “members”) that are conducted on a regular cycle basis: each firm is examined at least once every four years, and many are examined even more frequently. In connection with each of these examinations, FINRA prepares a report—which is available only to the relevant firm—addressing certain aspects of the firm’s compliance with securities rules and regulations. Firms are required to address issues identified by FINRA, and many do so by proactively taking corrective action before FINRA concludes its exam. Through this sort of rapid remediation, firms strengthen their compliance and supervisory programs, which ultimately helps better protect investors and the integrity of the markets.

FINRA is issuing this report as another resource that firms can use to strengthen their compliance with securities rules and regulations. Some firms have requested that FINRA make generally available a summary of observations from the cycle examination program, so that they can further improve their compliance functions based on the experiences of other firms, and better anticipate and address potential areas of concern well before their own cycle examinations.

This report focuses on selected observations from recent examinations that FINRA considers worth highlighting due to their potential impact on investors and markets or the frequency with which they occur. This report does not represent a complete inventory of observations about the industry as a whole, does not imply that any issues discussed exist at any particular firms, and should not be read as creating new legal or regulatory requirements or new interpretations of existing requirements. An individual firm may not have any deficiencies in the risk areas identified in the report.

This report also describes certain practices that FINRA has observed to be effective in appropriate circumstances, which other firms may be able to use as a resource in tailoring their compliance and supervisory programs to their business. There should be no inference, however, that FINRA requires firms to implement any specific practices described in this report that extend beyond the requirements of existing securities rules and regulations.

AREPORTFROMTHE FINANCIAL INDUSTRY REGULATORY AUTHORITY

Report on FINRA Examination Findings


FINRA expects that this report will evolve over time as we work to ensure that it is helpful in supporting firms’ compliance and supervisory efforts. FINRA welcomes feedback on how we could make future reports on examination findings more useful. If you have suggestions, please contact Daniel M. Sibears, Executive Vice President, Regulatory Operations/Shared Services, at (202) 728-6911; or Steven Polansky, Senior Director, Regulatory Operations/Shared Services, at (202) 728-8331.

Highlighted Observations

Cybersecurity

Cybersecurity is one of the principal operational risks facing broker-dealers. Recent revelations regarding successful attacks at a number of different entities underscore the need for firms to be vigilant in addressing cybersecurity threats. FINRA has focused on sharing information to help firms better protect their customers and themselves, including through recommendations offered in connection with an examination.1 The primary federal securities law provision governing a firm’s cybersecurity program is SEC Rule 30 of Regulation S-P, which requires firms to have written policies and procedures addressing the safeguarding of customer information and records.

FINRA has seen a significant increase in firms’ attention to cybersecurity challenges over the past two years, including at the executive management level. Awareness about cybersecurity risk has increased substantially. Most firms we examined have established, or were establishing, risk management practices, although the quality of those practices varied substantially both within and across firms. In some cases, firms adopted and executed, on an ongoing basis, formal risk management practices that executive management approved and applied on a consistent, firmwide basis. And some of the firms we regulate are leaders in developing and adopting cutting-edge cybersecurity practices.

Firms with effective cybersecurity programs typically established strong governance structures and processes (scaled to the firm) that addressed cybersecurity in a risk management context. Firms escalated risk acceptance decisions and problems to the appropriate levels for resolution, as well as to inform future program development. Measures firms implemented included regular risk assessments with detailed, time-bound follow-up action plans to resolve higher-risk concerns. Firms supported these assessments with regular vulnerability and penetration tests. Firms also required employees to participate in regular, role-specific and generic cybersecurity training and testing, for example, through phishing email exercises. Firms with branch offices developed and implemented robust branch cybersecurity reviews as part of their branch examination programs. As appropriate to their scale, some firms implemented security information and event management, system usage behavior analytics and data loss prevention tools to identify, monitor, and address potentially anomalous or suspicious activity on their networks.


Selected Examination FindingsAs the nature and sophistication of cybersecurity threats continue to evolve, even robust cybersecurity programs can be compromised when, for example, an employee opens an email attachment that contains malware. Common threats FINRA observed in 2016 and 2017 include phishing and spearphishing attacks,2 ransomware attacks and fraudulent third-party wires that frequently involve use of email or stolen customer or financial advisor credentials.

FINRA observed a variety of areas where some firms could improve their cybersecurity programs against these and other threats.3 These areas include:

00 Access Management – Some firms FINRA examined did not address basic access management issues such as terminating departing employees’ access to firm systems on a timely basis. In the case of privileged systems users, some firms did not implement procedures to log, monitor and supervise their activities to detect anomalies such as a privileged user assigning herself or himself extra access rights, performing unauthorized work during off-hours or logging in from different geographic locations concurrently.4

00 Risk Assessments – Some firms did not have formal processes to conduct ongoing risk assessments of their data, systems and applications, and could not effectively identify their critical assets and the potential risks to those assets.

00 Vendor Management – Some firms did not have formal processes to review a prospective vendor’s cybersecurity preparedness or to ensure new vendors have appropriate protections in place. For example, some firms’ contracts with vendors did not address key questions such as the vendor’s responsibilities regarding notification to the firm in the event of a breach of customer or firm data. In cases where firms contracted with a parent organization for cybersecurity services, the parent’s cybersecurity responsibilities were not sufficiently documented, such as in a service-level agreement.

00 Branch Offices – FINRA found that firms’ branch offices typically faced greater challenges in managing passwords, implementing patches and software updates, updating anti-virus software, controlling removable storage devices, encrypting data and reporting incidents.

00 Segregation of Duties – FINRA observed some medium- and small-sized firms that did not segregate the responsibilities for requesting, implementing, and approving cybersecurity rules and systems changes. For example, some firms allowed application developers to access sensitive data in production systems and in some cases implement application code into production without appropriate oversight. In other cases, network engineers performed cybersecurity and information security functions without formal management oversight.

00 Data Loss Prevention – FINRA observed that while larger- and medium-sized firms had implemented data loss prevention tools, there were opportunities to strengthen those implementations, including broadening rules that prevent transmission of Social Security numbers to include additional sensitive data such as customer account numbers; establishing thresholds to flag or block large file transfers to outside and untrusted recipients; and implementing formal change-management processes for data loss prevention system rule changes.


Outside Business Activities and Private Securities Transactions

FINRA Rules 3270 and 3280 require registered representatives to notify their firms of proposed outside business activities (OBAs), and all associated persons to notify their firms of proposed private securities transactions (PSTs), so firms can determine whether to limit or allow those activities to proceed. Certain OBAs and PSTs could potentially involve misconduct or create conflicts of interest that may expose both firms and customers to potential risks. The notifications required in the rules assist firms in identifying and determining how to mitigate those risks, including by placing conditions on, or prohibiting, participation in the proposed OBA or PST.5

Firms that had effective programs to manage OBAs and PSTs typically implemented proactive compliance efforts, particularly at the branch level. Firms used frequent training to make registered or associated persons aware of their responsibilities with respect to OBAs and PSTs, including the requirements to provide a firm prior written notice of a proposed activity. Firms also required these individuals to complete open-ended questionnaires and attestations regarding their involvement—or potential involvement—in OBAs and PSTs on a regular basis. Firms implemented various tools to identify individuals involved in undeclared OBAs and PSTs, including monitoring correspondence, fund movements, marketing materials, employee online activities and customer complaints. This also included monitoring for evidence of involvement in OBAs or PSTs the firm had prohibited.

Selected Examination FindingsFINRA observed instances in all sizes of retail brokerage firms in which registered persons, other associated persons or firms failed to meet one or more of their obligations under the rules. These instances include problems related to:

00 Notice – FINRA observed that some individuals failed to notify their firms of proposed OBAs or PSTs, including situations where a new hire or current registered or associated person failed to notify their prospective or current firm in writing of an existing OBA or PST. In some cases, individuals did not understand what constitutes an OBA or PST, or did not satisfy important provisions of the rules (e.g., the requirement for written rather than verbal notice). In other cases, individuals failed to provide the information with sufficient detail for a firm to make an adequate determination as to whether to allow a proposed OBA or PST to proceed.

00 OBA and PST Notice Reviews – FINRA observed weaknesses in some firms’ OBA and PST reviews. In some instances, firms either did not have written supervisory procedures for such reviews or the procedures were inadequate. FINRA also observed instances where firms had well-designed procedures, but executed them poorly, either through a lack of supporting documentation or a failure to execute their reviews with sufficient depth. In particular, some firms construed “compensation” too narrowly, erroneously determined that an activity was not a PST, or approved participation in a proposed transaction without adequately considering whether they could supervise the transaction as if it were executed on their own behalf.

00 Post-PST Approval – FINRA observed several problems once firms decided to approve PSTs for compensation. Some firms did not fully understand the activity and, as a result, failed to supervise it effectively. Other firms did not retain the documentation necessary to demonstrate their compliance with the supervisory obligations. In addition, firms sometimes had difficulty recording the transactions on their books and records because PSTs can take many forms and the uniqueness of their structures may not fit easily into firm electronic systems that are designed with fields tailored to a firm’s existing business.6 Some firms failed to monitor limitations placed on the PST, such as a prohibition on a registered representative soliciting firm clients to participate in the PST.


Anti-Money Laundering Compliance Program

Following the terrorist attacks of September 11, 2001, Congress passed the USA PATRIOT Act, in part, to strengthen the anti-money laundering (AML) and counter-terrorist financing provisions of the Bank Secrecy Act (BSA) and extend them to broker-dealers. Among other provisions, the BSA requires firms to monitor for, detect and report suspicious activity to the U.S. Treasury’s Financial Crimes Enforcement Network (FinCEN).

FINRA Rule 3310 requires that members develop and implement a written AML program reasonably designed to comply with the requirements of the BSA, and the implementing regulations promulgated thereunder by the Department of the Treasury.7

FINRA observed that firms with effective AML programs actively tailor their risk-based AML program to the firm’s business model and associated AML risks as opposed to simply implementing a more “generic” program. They also conducted independent testing that included sampling customer accounts in order to test whether the firm was collecting and verifying customer identification information on all individuals and entities that would be considered customers under the BSA, as well as trading and money movement activity to test whether the firm was performing adequate monitoring for and investigations of potentially suspicious activity. In addition, they designed training programs that were specific to the roles and responsibilities of the participating employees and captured current and evolving aspects of the AML landscape.

Selected Examination FindingsFINRA observed instances where firms failed to establish and implement an AML program reasonably designed to detect, and cause the reporting of, suspicious activity.

00 Maintaining Adequate Policies and Procedures for Suspicious Activity – Some firms failed to establish and implement risk-based policies and procedures to detect and report suspicious transactions. FINRA identified these deficiencies where, for example, a firm’s business growth far outpaced the growth of its AML programs, a portion of a firm’s business involved a high-risk product (such as microcap securities or dual currency bonds), or a firm’s business evolved over time and AML policies and procedures were not updated and adequately tailored to the firm’s current risks, including with respect to how potentially suspicious activity would be monitored and documented.

00 Responsibility for AML Monitoring – While firms are permitted to delegate aspects of their suspicious activity monitoring program to non-AML staff (e.g., to business line staff responsible for trade surveillance), in some cases where this was done, FINRA observed that problems sometimes arose with the appropriate and adequate escalation of potentially suspicious activity. Those problems typically occurred when the AML and surveillance staff did not share a common understanding of the types of activities that merited escalation or when staff did not escalate such activities appropriately. In some cases, the problems occurred because firms did not: (1) clearly define the activities that were being delegated; (2) articulate those delegations and related surveillance responsibilities in their written supervisory procedures; or (3) adequately train non-AML staff on AML surveillance policies and procedures.

00 Exclusions From Data Feeds Used for AML Monitoring – FINRA also observed instances where firms’ monitoring systems were deficient due to gaps in the data feeding those systems that were created, for example, by the use of “suspense accounts” to process foreign currency money movement and conversion. The use of suspense and other operational accounts sometimes obscured the source of funds to firms’ surveillance systems, resulting in weaker monitoring of high-risk transactions. FINRA also observed instances where firms made decisions to exclude certain types of customer accounts from monitoring programs, but failed to document or, if circumstances changed, revisit the risk-based rationale for the decision, again resulting in unidentified suspicious activity.


00 Resources for AML Monitoring – FINRA also identified deficiencies due to policies and procedures not being implemented as a result of firms not providing adequate resources to AML departments to carry out the responsibilities of the AML program. This result was more common when a firm experienced significant growth but did not grow the firm’s AML program commensurately. The lack of resources can lead to deficient monitoring or inadequate investigations of potentially suspicious activity.

00 Independent Testing of AML Monitoring – FINRA also observed that some firms did not ensure the independent testing required under FINRA Rule 3310(c) included a review of how the firm’s AML program was implemented. Other weaknesses included firms not ensuring the independence of the test, or not completing tests on an annual calendar year basis where the firm’s business warranted that regular testing.

Product Suitability

FINRA Rule 2111 states that a “member or an associated person must have a reasonable basis to believe that a recommended transaction or investment strategy involving a security or securities is suitable for the customer, based on the information obtained through the reasonable diligence of the member or associated person to ascertain the customer’s investment profile.” In addition, FINRA Rule 3110 obligates firms to establish and maintain a system to supervise the activities of associated persons that is reasonably designed to achieve compliance with applicable securities laws and regulations and FINRA rules.

The concerns that FINRA had during the course of examinations with regard to the suitability of certain products and their supervision did not vary materially by firm size, but did occur more frequently in connection with certain product classes, specifically unit investment trusts (UITs) and certain multi-share class and complex products, such as leveraged and inverse exchange-traded funds (ETFs). FINRA observed firms that implemented a variety of effective practices in recommending the purchase or sale of these products, which included thoroughly training registered representatives on products’ performance and risk characteristics, as well as establishing criteria to consider in determining whether a product was suitable for a specific customer; communicating product risks to customers in a way those customers could understand; and tailoring supervisory systems to products’ features and sources of risk to customers. For example, with respect to UITs, FINRA observed firms that alerted customers to the consequences of selling and reinvesting in a new UIT prior to the initial UIT’s maturity using negative or positive consent letters. Some firms implemented surveillance patterns to identify early UIT rollovers under a variety of scenarios. In addition, some firms required registered representatives to enter a rationale into firm systems for each short-term UIT transaction and coupled the entry with documented supervisory review.

Selected Examination Findings00 UITs

UITs are generally structured portfolios with maturities aligned to meet the objective of the strategy. Typically, the vast majority of UITs purchased are not traded or redeemed significantly in advance of maturity without a customer-specific need for liquidation or specific changes in the economic environment. Given that registered representatives earn most of the fees associated with UITs at or shortly following the initial offering period, there is a risk that they may recommend early rollovers or exchanges to increase their sales credits.

FINRA identified instances in which customers were advised to roll their UIT investments over early, and firms did not have appropriate supervisory mechanisms in place to identify and review the suitability of the recommendation.8 This practice causes investors to incur additional sales charges, including both creation and development fees and deferred sales charges.


Some firms FINRA reviewed failed to adequately identify short-term UIT trading activity as an area of potential abuse by registered representatives, and did not implement adequate internal controls to identify potentially problematic UIT trading activity. For example, some firms’ systems and processes looked at individual short-term UIT trades in isolation, but did not have processes to capture patterns of short-term UIT trades across customer accounts, registered representatives, branch office location, or to look for patterns of series-to-series UIT trading, excessive early liquidations followed by subsequent purchases, or cross-product trading partially involving UITs.

FINRA observed that the quality of a firm’s supervision for potentially problematic short-term trading of UITs was often correlated with the degree of specificity in a firm’s definition of such trading. Some firms defined a UIT short-term trade to include multiple scenarios (e.g., rollovers, early rollovers, exchanges, series-to-series transactions prior to an approaching maturity). By contrast, other firms had more limited definitions (e.g., excluding early rollovers). This more limited definition reduced the efficacy of the firm’s supervision and surveillance.

00 Multi-Share Class and Complex Products

FINRA found that some firms failed to meet their suitability obligations with respect to individual customers when recommending multi-share class or complex products. For example, FINRA observed situations where firms: (1) recommended a higher-fee share class without a reasonable basis to believe that the recommendation was suitable; or (2) recommended a complex product without a reasonable basis to believe the product was suitable in light of the customer’s risk tolerance and investment time horizon. In some instances, firms also failed to seek to obtain key pieces of investor profile information, without providing a reasonable basis for failing to do so.

In addition, FINRA observed that some firms failed to establish and implement adequate supervisory systems and written supervisory procedures with regard to multi-share class and complex products. At one firm, for example, FINRA observed that in a sample of short-term surrender variable annuity transactions, over 50 percent of customers had a long-term investment time horizon. Despite this appearance of a conflict with the recommendation to purchase the short-term surrender annuity, FINRA found no evidence in most of the transactions that the firm had performed a supervisory review addressing these concerns. At other firms, FINRA found that the suitability of recommendations for the purchase of leveraged or inverse ETFs had not been subject to adequate supervisory reviews.9

00 Training

Some firms failed to provide adequate training for registered representatives with respect to suitability issues, particularly regarding the products described above. Consequently, they were neither sufficiently knowledgeable to make customer-specific suitability determinations nor to advise customers effectively on the risks those products entailed. In the case of UITs, for example, firms that relied on written supervisory procedures and compliance bulletins to inform their registered representatives and principals about UITs encountered more sales practice problems than firms that implemented UIT-focused training for registered representatives.


Best Execution

Best execution is a significant investor protection requirement that essentially obligates a broker-dealer to exercise reasonable care to execute a customer’s order in a way to obtain the most advantageous terms for the customer. As the circumstances of each order and trading environment vary, so does the determination of what is best execution. Broker-dealers must be cognizant of the duty of best execution they owe customers when they receive, handle, route or execute customer orders in equities, options and debt securities. If a broker-dealer receives an order-routing inducement, such as payment for order flow, or trades as principal with customer orders, it must not let those factors interfere with its duty of best execution nor take them into account in analyzing market quality.

Generally, FINRA Rule 5310 requires that in any transaction for or with a customer or a customer of another broker-dealer, a member and persons associated with a member, shall use reasonable diligence to ascertain the best market for the subject security, and buy or sell in such market so that the resultant price to the customer is as favorable as possible under prevailing market conditions.

In lieu of an order-by-order review, the rule permits firms that route customer orders to other broker-dealers for execution on an automated, non-discretionary basis, as well as firms that internalize customer order flow, to conduct a periodic (at least quarterly) regular and rigorous review of execution quality likely to be obtained from different market centers.10

FINRA observed firms that established, maintained, and enforced policy and supervisory procedures regarding regular and rigorous reviews for execution quality, including a description of the reviews performed and how the conduct and results of the reviews should be documented. Those firms documented their conduct of such reviews, the data and other information considered, order routing decisions and the rationale used. This is important not only to allow firms to make appropriate routing decisions, but also so that a regulator will understand what information was considered and why.

Selected Examination FindingsFINRA had concerns regarding the duty of best execution at firms of all sizes that receive, handle, route or execute customer orders in equities, options and fixed income securities.11 FINRA found that some firms failed to implement and conduct an adequate regular and rigorous review of the quality of the executions of their customers’ orders. These deficiencies included:

00 failing to compare the quality of the executions firms obtained via their order routing and execution arrangements (including the internalization of order flow) against the quality of the executions they could have obtained from competing markets;

00 failing to conduct reviews of certain types of orders (i.e., market, marketable limit and non-marketable limit orders); and

00 failing to consider certain factors set forth in FINRA Rule 5310 when conducting a regular and rigorous review, such as speed of execution, price improvement and the likelihood of execution, among others.

As a result of such deficiencies, these firms failed to assure that order flow was directed to markets providing the most beneficial terms for their customers’ orders. FINRA notes that conducting a regular and rigorous review of customer execution quality is critical to the supervision of best execution practices, particularly if a firm routes customer orders to an alternative trading system in which the firm has a financial interest or market centers that provide order routing inducements, such as payment for order flow arrangements and order routing rebates.12


Market Access Controls

As trading in the U.S. securities markets has become more automated, the potential impact of a trading error or a rapid series of errors—caused by a computer or human error, or a malicious act—has become more severe. The SEC adopted Securities Exchange Act (SEA) Rule 15 c3-5 (referred to as the SEC’s “Market Access Rule”) to require broker-dealers with market access or that provide market access to their customers to “appropriately control the risks associated with market access so as not to jeopardize their own financial condition, that of other market participants, the integrity of trading on the securities markets, and the stability of the financial system.”13 For such broker-dealers, the Market Access Rule applies to trading in all securities on an exchange or alternative trading system, including equities, options, ETFs, debt securities (including municipals and treasuries) and security-based swaps.

FINRA observed firms that provide market access implement a variety of effective controls to help satisfy the requirements of SEA Rule 15c3-5, such as maintaining reasonable documentation to support thresholds; conducting periodic reviews that assess the reasonableness of thresholds (e.g., through a credit or capital utilization review); aggregating capital or credit usage limits by assigning finely tuned or granular limits, which in total represent a reasonable threshold, or by aggregating across applicable measures (e.g., accounts and systems) on a pre-trade basis; and establishing well-defined procedures that clearly describe the process to adjust a threshold both on an intra-day and permanent basis.14

Selected Examination FindingsFINRA observed several areas where some firms that provide market access fall short of their obligations under SEA Rule 15c3-5, particularly with respect to the establishment of pre-trade financial thresholds, implementing and monitoring aggregate capital or credit exposures, and tailoring erroneous trade controls.

FINRA also found that some firms did not appropriately apply the Market Access Rule to some or all of their fixed income activities. The Market Access Rule applies to any of a firm’s fixed income trading activity directed to an alternative trading system or exchange, including from a firm’s proprietary and principal trading desks, even if such activity represents a small percentage of the firm’s overall fixed income trading activity.15

00 Establishing Pre-Trade Financial Thresholds – FINRA observed instances in which firms failed under the Market Access Rule to establish reasonable pre-trade financial thresholds (capital and credit), or to undertake reasonable due diligence to substantiate those firm-assigned thresholds. For example, in one examination, FINRA noted that a firm assigned unreasonably high financial thresholds to its broker-dealer affiliate and was unable to provide any empirical data to support those thresholds. Certain single-trader IDs within the affiliate were assigned buying power of hundreds of millions of dollars and had a combined buying power of several billion dollars. The firm also lacked any substantiation of the reasonableness of those thresholds.

00 Implementing and Monitoring Aggregate Financial Exposures – FINRA observed instances where firms did not adequately consider capital and credit usage in the aggregate.16 FINRA also observed instances where firms providing market access lacked procedures on how to request, review, or approve adjustments to capital or credit thresholds. Often such adjustments were made on an ad hoc basis (e.g., in expectation of increased order flow in response to a market event, such as an index rebalancing) and not sufficiently documented. In some cases, the firm did not reset the adjusted levels or maintain documentation to support a permanent increase in the capital or credit threshold.


00 Tailoring Erroneous or Duplicative Order Controls – Striking a reasonable balance between preventing potentially erroneous or duplicative orders while not unduly inhibiting trading can be challenging. FINRA observed instances in which firms did not appropriately tailor their erroneous or duplicative order controls to particular products, situations or order types. For instance, firms use an “away from the market” control to prevent erroneous orders.17 However, relying solely on this control may put a firm at risk when entering large market orders, as there is no limit order price reference point. An effective practice that FINRA has observed to reasonably prevent erroneous orders of this type is to employ a market impact check, which measures the size of a customer’s order compared to the average daily volume in that security. If a check of this type is used, it should be set at a reasonable level.18

FINRA also observed situations where a firm had not considered the character of the market at the time of order entry. For instance, firms that only used the “away from the market” control may have created issues at times when the NBBO may not have been indicative of the true market.19 When the NBBO spread is above a preset percentage, FINRA has observed that one effective practice to prevent erroneous orders is for the firm to establish an alternative reference point, such as a control that measures the order price as a percentage away from last sale as opposed to the NBBO.

00 Implementing Effective Fixed Income Financial Controls – FINRA observed that in some instances, firms were not implementing the required systemic pre-trade “hard” blocks to prevent fixed income orders from reaching an alternative trading system that would cause the breach of a threshold. These firms implemented either “soft” blocks that provided warnings, but did not stop (automatically or manually) orders in breach of a threshold from being executed, or post-execution controls. One firm’s systems permitted a customer to enter an additional order that breached the customers’ credit thresholds before imposing the hard block. In some cases, firms that initially implemented controls to address the rule’s requirements failed to establish market access controls as they added new alternative trading systems.

00 Reliance on Vendors for Fixed Income Financial Controls – Firms may rely on an outside vendor’s tools, including those of an alternative trading system, to effect their financial controls, but they must have direct and exclusive control over the mechanisms that have been established and remain responsible for compliance. However, FINRA observed some firms that allowed the alternative trading system to set capital thresholds for their fixed income orders instead of establishing their own thresholds. Occasionally, firms were not sure what their thresholds were, and had no means to monitor their usage during the trading day. Some firms failed to understand how their vendors’ controls worked and could not explain them to FINRA.

00 Effective Testing for Fixed Income Financial Controls – Firms also must periodically test their market access controls, which forms the basis for an annual CEO certification attesting to a firm’s controls. FINRA found that in some instances, firms either failed to conduct any tests at all for their fixed income orders, or relied on their vendors to perform the tests without appropriate due diligence by the firm.


Summary of Additional ObservationsIn addition to the topics we address above, FINRA also draws firms’ attention to the following areas where operational deficiencies have challenged some firms’ ability to meet their compliance obligations.

Alternative Investments Held in Individual Retirement Accounts (IRAs)

FINRA has identified instances in which firms that carry customers’ alternative investment assets held in IRAs failed to apply the requirements of financial and operational rules applicable to those assets.20

00 Failure to Establish Possession or Control as Required by SEA Rule 15c3-3 (referred to as the SEC’s “Customer Protection Rule”) – In some instances, firms that maintained custody of customers’ alternative investment assets held in IRAs did not satisfy the requirements for establishing possession or control as per the SEC’s Customer Protection Rule and the interpretations thereunder. This problem was observed in instances when firms sold alternative investment assets to customers through their own platform, and also when firms accommodated customers and provided custody for such assets that customers obtained elsewhere, but erroneously concluded they had not taken on custodial responsibilities.

00 Incorrect Account Statements – FINRA also observed instances where a firm maintained custody of customers’ alternative investment assets held in IRAs, but incorrectly reflected customer positions on the customer account statements as assets that were not in the custody of the firm.

00 Inaccurate Net Capital and Reserve Formula Computations – Some firms prepared inaccurate net capital and reserve formula computations pursuant to SEC rules with respect to alternative investment assets they carried. This issue occurred when firms failed to perform required quarterly verifications of customers’ alternative investment account positions and consequently could not factor reconciliation differences into those calculations.

Net Capital and Credit Risk Assessments

FINRA observed that, in seeking to comply with SEA Rule 15c3-1 (referred to as the SEC’s “Net Capital Rule”) and the interpretations thereunder, some firms faced challenges assessing the creditworthiness of non-convertible debt or money market instruments they held in their inventory for client facilitation or other purposes. These challenges increased following the effective date for compliance with amendments to SEC rules that removed references to credit ratings in order to reduce reliance on credit rating agencies and help ensure that haircut charges for certain securities for purposes of net capital computations are consistent with market data.21 FINRA observed issues principally in six areas:

00 Inadequate Policies and Procedures – In some instances, firms did not adequately design or document their policies and procedures for assessing and monitoring creditworthiness.

00 Inappropriate Use of Thresholds for Conducting Assessments to Determine if Securities Have Minimal Credit Risk – Pursuant to the SEC rule, firms are permitted to apply either a 15 percent haircut to all of their preferred stock, debt securities and money market instruments that have a ready market, or a lower haircut on such securities if it is determined that they have minimal credit risk pursuant to policies and procedures as specified under the Net Capital Rule. FINRA has noted instances where firms first applied the lower haircut to all such securities and then used a threshold to determine for which of those securities they would perform an analysis to determine minimal credit risk. However, the rule makes no allowance for a de minimis threshold below which the required creditworthiness assessment need not be performed.


00 Misapplication of SEC No-Action Letters – FINRA noted instances where firms incorrectly applied the criteria in SEC no-action letters for determining whether a security may be deemed to have a “ready market” to certain securities that are not within the scope of those letters. In particular, FINRA noted instances where firms incorrectly applied guidance for high-yield bonds to asset-backed securities held in their inventory. In other instances, firms did not properly apply the haircut charges prescribed in the no-action letters, and as a result applied lower haircut charges not consistent with the SEC staff’s guidance.

00 Failure to Apply Proper Charges for Open Contractual Commitments – FINRA noted instances where firms applied lower haircut charges to their open contractual commitments without performing the required assessment of creditworthiness as required by SEA Rule 15c3-1(c)(2)(vi)(I).

00 Improper Use of Indices as Benchmarks for Credit Risk Assessments – Some firms incorporated indices or other data into their procedures as benchmarks to assess the credit worthiness of an instrument, but did not reasonably design their use of such benchmarks to be consistent with the Net Capital Rule. For example, some firm procedures used certain benchmarks, but then did not articulate the levels at which the benchmarks would indicate a minimal amount of credit risk.

00 Inappropriate Use of Internal or External Credit Risk Assessments – Firms may incorporate credit ratings developed by an affiliate into their own procedures for assessing creditworthiness, but SEC rules require that procedures informed by such ratings must still be reasonably designed to result in assessments of creditworthiness that typically are consistent with market data. FINRA observed some instances where the use of an affiliate’s credit ratings did not support such procedures, such as one instance where the ratings used in the procedures were not kept current.

Order Capacity

FINRA observed that firms of all sizes that engage in an equities business sometimes failed to comply with the requirement to enter the correct capacity code (e.g., agency, principal, riskless-principal) when reporting an off-exchange trade to a FINRA equity trade reporting facility.22

Specifically, FINRA observed firms that failed to reasonably address requirements in the development and programming of record keeping and order entry systems, maintain written supervisory procedures reasonably designed to achieve compliance with trade reporting rules, adequately train employees with respect to the significance of properly marking capacity in order entry systems, and adequately supervise employees with respect to the proper marking. These failures resulted in, among other issues, deficiencies in the proper marking and reporting of numerous orders or executions by firms’ proprietary or vendor-provided systems.

In the case of equity reporting to a FINRA facility, FINRA continued to identify firms that incorrectly reported riskless principal transactions as agent, or agency transactions as riskless principal transactions. These errors reflected some firms’ misunderstanding of the key distinction between agency and riskless principal transactions: the former do not traverse through the firm’s principal accounts, unlike principal and riskless principal transactions.


Regulation SHO

FINRA observed some instances in which firms have had difficulty meeting various aspects of their obligations under Regulation SHO and relevant FINRA rules:

00 Supervision of Third-Party Order Management Systems – FINRA found that some firms may be overly reliant upon a third-party order management system for supervisory and compliance functions. FINRA noted inadequate levels of firm review and verification that third-party systems properly accounted for open sell orders as required by FAQ 2.5 concerning Regulation SHO and properly marked orders in accordance with Rule 200(g) of Regulation SHO.

00 Trading Records From Third-Party Order Management Systems – Some firms were hindered from adequately conducting these supervisory reviews as a result of limitations with vendor-provided information and data and vendor non-responsiveness. FINRA found that some third-party vendors did not provide firms with trading records that would permit a review of order marking for compliance with Rule 200(g) of Regulation SHO and FAQ 2.5. Specific limitations that FINRA identified included: (1) firms that were unable to obtain trading records that provided proprietary order information (as opposed to trade execution information); (2) vendors that did not have a single report that captured proprietary order information; and (3) vendors that did not provide trading data in a format that firms could use to conduct testing and review for order marking (e.g., PDF documents that could not be converted to a more easily useable format).

00 Locate Obligations – FINRA observed weaknesses in various aspects of certain firms’ locate practices. In some cases, firms continued to provide locates after depleting available shares, while in others there were weaknesses in some firms’ processes to document manual locates after available shares were depleted. FINRA also found that firms failed to establish proper controls to ensure that “easy to borrow” lists were accurate and updated timely to reflect current market or other conditions, such as existing fails to deliver or securities designated “hard to borrow.”

00 Fail-to-Deliver Closeouts – FINRA observed instances where firms did not maintain adequate written supervisory procedures for complying with Rule 204 of Regulation SHO regarding closeout of fails to deliver. The procedures did not address, for example, actions to be taken when transactions in American Depository Receipts did not settle on the applicable settlement date or how firms would ensure their books and records are net flat or net long on a day when a closeout obligation existed.

TRACE Reporting

FINRA observed some firms that engaged in institutional sales of fixed income securities frequently did not comply with certain key TRACE reporting rules—FINRA Rules 6730(a)(7),23 6730(b)(1) and (2),24 and 6730(c)(8).25 Specifically, FINRA found that some firms:

00 failed to report transactions in some TRACE-eligible securities because they relied on the master list of TRACE-eligible securities published by FINRA, and did not have a system or process to determine if a transaction involved a security that was not set up in TRACE at the time of the transaction;

00 reported transactions to TRACE late—more than 15 minutes from the time of execution— and inaccurately, providing the execution time as the time the transaction was entered into the firm’s order management system, not the actual time of execution; and

00 failed to detect deficiencies such as those described above, in part because they failed to establish and maintain a supervisory system reasonably designed to achieve compliance with certain TRACE reporting obligations.


1. For additional information on cybersecurity, including FINRA’s Small Firm Checklist, please see FINRA’s cybersecurity topic page.

2. “Spearphishing” is an email attack that typically targets an individual or set of individuals with emails that appear to be from an entity or person known to the target.

3. Some of these observations are more relevant to large firms or firms with a highly technology-dependent business model.

4. A “privileged user” is typically a systems, server, network or a database administrator with unrestricted access to powerful commands that enable him or her to create other users, assign access rights, create, copy, delete, and modify any files and databases, build new servers in production or shut down servers and systems. Often these users are assigned to a technology infrastructure department and support numerous business lines and systems across the whole organization.

5. On May 15, FINRA published Regulatory Notice 17-20 announcing that FINRA is conducting a retrospective review of the OBA and PST rules and requesting public comment on them. That request was made in the context of FINRA’s ongoing effort to review “significant rules to ensure they remain effective at protecting investors in an efficient manner.”

6. NASD Notice to Members 96-33 notes that a firm is “not required to record the activity in the same manner it records transactions executed on behalf of its own firm (i.e., on its purchase and sales blotter). Rather, members may develop and use alternative approaches that meet their specific needs and business practices …”

7. FINRA provides a free template for small firms to assist them in fulfilling their responsibilities to establish the AML compliance program required by the BSA, its implementing regulations, and FINRA Rule 3310. The template provides text examples, instructions, relevant rules and links to other resources that are useful in developing an AML plan for small firms.

8. FINRA bases its observations here on findings from our cycle examination program as well as a sweep FINRA conducted. The information request for the sweep can be found here.

9. Most recently, FINRA reminded firms of sales practice obligations for volatility-linked exchange-traded products in Regulatory Notice 17-32.

10. FINRA has noted in recent guidance that it believes order-by-order review of execution quality is increasingly possible for a range of orders in all equity securities and standardized options. See Regulatory Notice 15-46. If a firm chooses not to conduct an order-by-order analysis, a member must determine, based on its regular and rigorous review, whether any material differences in execution quality exist among the markets trading the security and, if so, modify the member’s routing arrangements or justify why it is not modifying its routing arrangements.

11. FINRA bases its observations here on findings from our cycle examination program as well as a sweep FINRA conducted. The information request for the sweep can be found here.

12. FINRA recently initiated targeted exams regarding the impact of order routing inducements on a firm’s order routing practices and decisions. The information request for the sweep can be found here.

13. Exchange Act Release No. 63241, 75 FR 69792 (Nov. 3, 2010).

14. These procedures included details on the approval process (who has the authority to override or change a threshold) and the steps leading up to that approval. Firms retained clear documentation to support these decisions, and for instances where a limit increase was given on an intra-day basis, procedures that addressed the readjustment of the limit.

15. While the Market Access Rule defines market access as the entry of orders on alternative trading systems and exchanges, with very limited exceptions, nearly all fixed income market access occurs on alternative trading systems.

16. The challenge of considering capital and credit usage in the aggregate generally arose where firms assigned multiple account identifiers or provided services that could create points where thresholds could be multiplied without appropriate monitoring of the aggregate impact. Scenarios that can result in a firm unwittingly multiplying thresholds include those that offer an individual customer multiple trading platforms to route orders to market centers, provide sponsored access or the use of other market center specific controls, establish multiple trading accounts for a single customer, including LLCs (Master/Sub-Accounts), and assign multiple user IDs, monikers or other identifiers to a single customer.

17. An “away from the market” control is a measurement of how far above (buy order) or below (sell order) the National Best Bid and Offer (NBBO) an order is priced. A firm typically assigns a percentage above which an order will be halted.

18. For example, one firm set its control threshold at an unreasonable 500 percent of the average daily volume of the security.

19. The general nature of trading makes the premarket session particularly vulnerable to this scenario. During the premarket, participants’ quotes trickle in and the NBBO spread narrows as the regular session opening approaches.

20. “Alternative investments” as used here refers to such products as, among other things, hedge funds, private equity funds, managed future funds, limited partnerships and non-traded Real Estate Investment Trusts (REITs).

21. For more information on the SEC’s 2013 credit ratings amendments, please see the SEC’s Adopting Release.

22. The FINRA/Nasdaq TRF, FINRA/NYSE TRF and OTC Reporting Facility are collectively referred to herein as the “FINRA Facilities.”

23. Providing that, if a member makes a good faith determination that a transaction involves a TRACE-eligible security, the member must report the transaction, and if the security is not set up in the TRACE system, the member must promptly contact FINRA prior to reporting the transaction.

24. Requiring that, in a transaction between two members, each member must submit a trade report and, in a transaction between a member and a non-member (including a customer) the member must submit a trade report.

25. Requiring that members report the time of execution of a transaction.

© 2017 FINRA. All rights reserved.17_0342.1 –11/17

Endnotes

http://www.finra.org/industry/cybersecurity

http://www.finra.org/sites/default/files/notice_doc_file_ref/Regulatory-Notice-17-20.pdf

https://www.finra.org/file/notice-members-96-33

http://www.finra.org/industry/anti-money-laundering-template-small-firms

http://www.finra.org/industry/unit-investment-trust-rollover-review

https://www.finra.org/sites/default/files/notice_doc_file_ref/Regulatory-Notice-17-32.pdf

http://www.finra.org/sites/default/files/notice_doc_file_ref/Notice_Regulatory_15-46.pdf

http://www.finra.org/industry/order-routing-and-execution-quality-customer-orders

http://www.finra.org/industry/order-routing-conflicts

https://www.gpo.gov/fdsys/pkg/FR-2014-01-08/pdf/2013-31426.pdf

SummaryFINRA seeks comment on proposed rule amendments that would impose additional restrictions on member firms that employ brokers with a history of significant past misconduct. These brokers, while relatively small in number, may present heightened risk of harm to investors, and any misconduct by them also may undermine confidence in the securities markets as a whole. The rule proposals would strengthen the existing controls, some of which are highlighted below, FINRA has applied to such brokers to further promote investor protection and market integrity.

The new proposals are one part of FINRA’s initiatives to confront high-risk brokers. FINRA will continue to evaluate various rules, examination and risk-monitoring programs, and technologies to determine further enhancements that FINRA can make to keep high-risk brokers from potentially harming investors and compromising the integrity of the financial markets.

FINRA is requesting comment on proposed amendments to:

1. the Rule 9200 Series (Disciplinary Proceedings) and the 9300 Series(Review of Disciplinary Proceedings by National Adjudicatory Counciland FINRA Board; Application for SEC Review) to allow a Hearing Panelto impose conditions or restrictions on the activities of member firmsand brokers while a disciplinary matter is on appeal to the NationalAdjudicatory Council (NAC), and to require member firms to adoptheightened supervisory procedures for brokers during the period theappeal is pending;

2. the Rule 9520 Series (Eligibility Proceedings) to require member firms toadopt heightened supervisory procedures for brokers during the period astatutory disqualification (SD) eligibility request is under review by FINRA;

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Regulatory Notice 18-16

April 30, 2018

Notice Type 00 Request for Comment

Suggested Routing00 Compliance00 Legal00 Operations00 Registered Representatives00 Senior Management

Key Topics00 BrokerCheck Disclosure00 Disciplinary Proceedings00 Eligibility Proceedings00 Heightened Supervision00 Statutorily Disqualified Persons00 Supervision00 Taping Rule

Referenced Rules & Notices00 FINRA Rule 311000 FINRA Rule 317000 FINRA Rule 831200 FINRA Rule 9200 Series00 FINRA Rule 9300 Series00 FINRA Rule 9520 Series00 FINRA Rule 955600 NASD IM-1011-100 NASD IM-1011-200 NASD Rule 1010 Series00 Regulatory Notice 18-15

High-Risk BrokersFINRARequestsCommentonFINRARuleAmendmentsRelatingtoHigh-RiskBrokersandtheFirmsThatEmployThem

CommentPeriodExpires:June29,2018

3. Rule 8312 (FINRA BrokerCheck Disclosure) to disclose the status of a member firm as a“taping firm” under Rule 3170 (Tape Recording of Registered Persons by Certain Firms);and

4. the NASD Rule 1010 Series (Membership Proceedings) (MAP rules) to place additionallimitations on member firms by requiring a member firm to first submit a written letterto FINRA’s Department of Member Regulation, through the Membership ApplicationProgram Group (MAP Group), seeking a materiality consultation when a natural personthat has, in the prior five years, one or more final criminal actions or two or morespecified risk events seeks to become an owner, control person, principal or registeredperson of an existing member firm. Specified risk events (as described in detail below)generally means final, adjudicated disclosure events disclosed on a person’s or firm’sUniform Registration Forms.1

The proposed rule text is available in Attachment A. With respect to proposal number 4, FINRA also seeks specific comment on the proposed numeric threshold and criteria that would trigger a materiality consultation. A detailed economic analysis of the proposed rule amendments, including the numeric threshold and criteria used for identifying brokers that would be impacted by the proposed amendments, is discussed below, and the exhibits referenced in this economic impact assessment are available in Attachment B, Exhibits 1, 2, 3 and 4.

In addition, FINRA is focusing attention on high-risk brokers by publishing Regulatory Notice 18-15 to reiterate the existing obligation of member firms to adopt and implement tailoredheightened supervisory procedures under Rule 3110 (Supervision) for high-risk brokers;2

and revising FINRA’s qualification examination waiver guidelines and related procedures tomore broadly consider past misconduct when considering examination waiver requests.3

Questions concerning this Notice should be directed to:

00 Kosha Dalal, Associate Vice President and Associate General Counsel, Office of General Counsel, at (202) 728-6903.

Questions concerning the Economic Impact Assessment in this Notice should be directed to:

00 Jonathan Sokobin, Senior Vice President and Chief Economist, Office of the Chief Economist (OCE), at (202) 728-8248; and

00 Hammad Qureshi, Senior Economist, OCE, at (202) 728-8150.

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http://www.finra.org/sites/default/files/Attachment-A_RN-18-16.pdf

http://www.finra.org/sites/default/files/Attachment-B_RN-18-16.pdf

Action RequestedFINRA encourages all interested parties to comment on the proposal. The comment period ends June 29, 2018.

Comments must be submitted through one of the following methods:

00 Emailing comments to [email protected]; or 00 Mailing comments in hard copy to:

Jennifer Piorko Mitchell Office of the Corporate Secretary FINRA 1735 K Street, NW Washington, DC 20006-1506

To help FINRA process comments more efficiently, persons should use only one method to comment on the proposal.

Important Notes: All comments received in response to this Notice will be made available to the public on the FINRA website. In general, FINRA will post comments as they are received.4

The proposed rule change must be filed with the Securities and Exchange Commission (SEC) pursuant to Section 19(b) of the Securities Exchange Act of 1934 (SEA or Exchange Act).5

Background & DiscussionFINRA uses a combination of tools to reduce misconduct by member firms and the brokers they hire, including SD processes, review of membership applications, disclosure of brokers’ regulatory backgrounds,6 supervision requirements, focused examinations, risk monitoring and disciplinary actions. These tools, among others, serve to further the Exchange Act goals reflected in FINRA’s mission of protecting investors and market integrity, including protecting investors from brokers with a history of significant past misconduct and the firms that choose to employ them.

Formal action to bar or suspend a broker requires FINRA to satisfy procedural safeguards established by federal law and FINRA rules to ensure fair process and to protect the rights of brokers to engage in business unless proven guilty of serious misconduct. Those safeguards include the right to defend oneself before a hearing panel and the right to appeal to the NAC, the SEC, and ultimately the federal courts. In addition, federal law and regulations define the types of misconduct that presumptively disqualify a broker from associating with a firm, and also govern the standards and procedures FINRA must follow when a broker who was found to have engaged in such misconduct applies to remain in or re-enter the industry.7

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mailto:[email protected]

CurrentPrograms

As discussed further below, FINRA strives to prevent and deter misconduct by member firms and the individuals they hire through a number of different measures.

00 Licensing and Registration

To become a FINRA member, a firm is subject to review through FINRA’s membership application program. As part of a new membership application (NMA) or a continuing membership application (CMA) under the Rule 1010 Series, FINRA reviews, among other factors, whether persons associated with an applicant have material disciplinary history, customer complaints, pending and final arbitrations, civil actions or other industry-related matters that could pose a threat to public investors. Where FINRA can show strong cause for concern, we can deny membership or place restrictions on membership to mitigate the risk. The membership application process also provides procedural safeguards for the applicant: applicants have the right to request review by the NAC of an adverse decision or the FINRA Board may call for a discretionary review of a membership proceeding. The applicant also may appeal final FINRA decisions to the SEC and the circuit courts.

00 Statutory Disqualifications – Eligibility Proceedings

FINRA administers the SD process by assessing applications from member firms that wish to retain or employ an individual who is the subject of an SD. In conducting the assessment, FINRA seeks to exclude individuals who pose a risk of recidivism from continuing in the securities business. As a general framework, the Exchange Act sets out the types of broker misconduct that presumptively exclude brokers from engaging in the securities business. These types of misconduct, entitled “statutory disqualifications,” are actions against an individual or member firm taken by a regulator or court based on a finding of serious misconduct that calls into question the integrity of the broker or firm. SDs include any felony and certain misdemeanors for a period of 10 years from the date of conviction; expulsions or bars (and current suspensions) from membership or participation in a self-regulatory organization; bars (and current suspensions) ordered by the SEC, Commodity Futures Trading Commission, or other appropriate regulatory agency or authority; willful violations of the federal securities and commodities laws or MSRB rules; and certain final orders of a state securities commission.

00 Monitoring and Examinations

FINRA addresses high-risk brokers or high-risk activity through several of its examination programs. First, FINRA executes a High-Risk Registered Representative (HRR) Program that uses various methodologies to identify brokers from across the entire securities industry whose individual risk profiles suggest they are more likely than the general broker population to engage in misconduct. A specialized High-Risk

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Registered Representative Examination Unit is responsible for the identification, monitoring and examination activities of high-risk registered representatives with additional examination support provided by examiners located in FINRA’s various district offices.

FINRA also reviews individual brokers as part of the firm examination program where every broker-dealer receives an examination at least once every four years. Because our firm examinations are risk-based, the focus on individual brokers varies depending on the specific firm. Also covered during these examinations are assessments of the firms’ supervisory and compliance controls over the conduct of brokers.

Further, FINRA examines individual brokers through its cause examination program. These examinations are allegation driven, and triggered by specific and sometimes high-risk events such as a customer complaint, whistleblower tip, arbitration referral or call to the FINRA Securities Helpline for Seniors™.

Lastly, FINRA conducts high-risk branch office examinations that focus on business conduct risks at the point of sale. Branch office examinations look at the core activities conducted from the specific branch location, including customer transactions, money and security movements, customer complaints, communications, account designation changes and credit extensions. The identification of high-risk branch offices is determined in large part by the aggregation of individual registered representative risk assessments.

00 BrokerCheck

BrokerCheck provides the public with information on the professional background, business practices, and conduct of FINRA member firms and their associated persons, as well as on firms and their associated persons who are registered with national securities exchanges that use the Central Registration Depository (CRD®). BrokerCheck information is derived from the CRD system to, among other things, help investors make informed choices about the individuals and firms with which they conduct business. In addition to BrokerCheck disclosure, FINRA publishes on its website a list of individuals who have been barred by FINRA from association with any member firm in any capacity.8 The list is updated on a monthly basis.

00 Supervision Obligations of Member Firms

FINRA Rule 3110 requires member firms to establish and maintain a system to supervise the activities of each associated person that is reasonably designed to achieve compliance with applicable securities laws and FINRA rules. Further, the rule requires member firms to establish, maintain and enforce written procedures to supervise the types of business in which it engages and the activities of its associated persons that are reasonably designed to achieve compliance with applicable securities

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laws and regulations and FINRA rules. An effective supervisory system plays an essential role in the prevention of sales abuses, and thus, enhances investor protection and market integrity. As such, FINRA has long emphasized that member firms have a fundamental obligation to implement a supervisory system, including written supervisory procedures, that is tailored specifically to the member firm’s business and addresses the activities of all its associated persons.9

00 Enforcement and Disciplinary Actions

An important part of FINRA’s supervision of firms and the individuals they employ is our ongoing enforcement of FINRA and MSRB rules, and federal securities laws and rules. We aggressively investigate potential securities violations and, when warranted, bring formal disciplinary actions against member firms and their associated persons.

With respect to problem individuals, FINRA can take a range of formal actions, including barring them from the industry. As previously noted, formal action to bar or suspend a broker requires satisfying procedural safeguards required by the Exchange Act and, with respect to FINRA actions, safeguards include the right to a hearing before a FINRA hearing panel; appeal to the NAC; appeal to the SEC; and ultimately to the circuit courts of appeal.

ProposedAmendments

As part of FINRA’s ongoing initiatives to protect investors from high-risk brokers, FINRA is proposing rule amendments that would impose additional obligations on member firms that seek to associate with high-risk brokers. The proposed rule amendments are designed to strengthen oversight of high-risk brokers and the firms that employ them.

1. Proposed Amendments to the Rule 9200 Series (Disciplinary Proceedings) and Rule 9300 Series (Review of Disciplinary Proceedings by National Adjudicatory Council and FINRA Board; Application for SEC Review)

A. Overview of Current Disciplinary Process

FINRA’s Department of Enforcement initiates a formal disciplinary action by filing a complaint with FINRA’s Office of Hearing Officers (OHO) when it believes that a member firm or associated person of a member firm is violating or has violated any FINRA rule, SEC regulations or federal securities laws, and formal disciplinary action is necessary. Following the filing of the complaint, the Chief Hearing Officer will assign a Hearing Officer to preside over the disciplinary proceeding, and appoint a Hearing Panel, or an Extended Hearing Panel, if applicable, to conduct a hearing and issue a decision.10

At a hearing, the parties present evidence for the Hearing Panel to determine whether a member firm or broker has engaged in conduct that violates FINRA rules, MSRB rules, SEC regulations or federal securities laws. The Hearing Panel also considers previous court, SEC, NAC and Hearing Panel decisions to determine if violations occurred.

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For each case, the Hearing Panel, or the Hearing Officer in the case of default decisions,11 will issue a written decision explaining the reasons for its ruling and consult the FINRA Sanction Guidelines to determine the appropriate sanctions if violations have occurred. FINRA also, when feasible and appropriate, can order member firms and brokers to make restitution to harmed customers.

Under FINRA’s disciplinary procedures, a member firm or broker has the right to appeal a Hearing Panel or Hearing Officer decision to the NAC, or the NAC may on its own initiate a review of a decision. On appeal, the NAC will determine if a Hearing Panel’s or Hearing Officer’s findings were legally correct, factually supported and consistent with FINRA’s Sanction Guidelines. The NAC’s decision constitutes a final disciplinary action of FINRA, unless the FINRA Board calls the case for review and issues its own decision. A member firm or broker may appeal a final disciplinary action of FINRA to the SEC, and further to a U.S. Court of Appeals.

Currently, while a Hearing Panel or Hearing Officer decision is on appeal to the NAC, any sanctions imposed by the Hearing Panel or Hearing Officer, including bars or expulsions, are automatically stayed and not enforced against the member firm or broker during the pendency of the appeal.12

B. Proposed Rule 9285 (Interim Orders While on Appeal)

FINRA is proposing new FINRA Rule 9285 (Interim Orders While on Appeal) to bolster investor protection during the pendency of an appeal to the NAC of a Hearing Panel or Hearing Officer decision.

00 Conditions and Restrictions

Proposed Rule 9285(a) would provide that the Hearing Panel or, if applicable, the Extended Hearing Panel, or Hearing Officer may impose such conditions or restrictions on the activities of a respondent as the Hearing Panel or Hearing Officer considers reasonably necessary for the purpose of preventing customer harm.13 This approach would be consistent with the rules of several exchanges that have provisions that allow an exchange adjudicator to impose restrictions on the respondent during the exchange’s appeal process.14

Under the proposal, as part of the hearing, FINRA’s Department of Enforcement could request that the Hearing Panel or Hearing Officer order conditions and restrictions imposed against the respondent. The Hearing Panel or Hearing Officer would consider the request at the same time it makes findings of violations and imposes sanctions for the misconduct. FINRA believes the Hearing Panel’s or Hearing Officer’s knowledge about the violations would provide the qualifications to evaluate the potential for customer harm and craft tailored conditions and restrictions to minimize that potential harm. The order would describe the activities that the respondent shall refrain from taking and any conditions imposed.

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http://www.finra.org/industry/sanction-guidelines

In considering whether conditions or restrictions should be imposed on the activities of a respondent, the Hearing Panel or Hearing Officer would be guided by the principle of imposing conditions and restrictions reasonably necessary for the purpose of preventing customer harm. These conditions or restrictions could include, for example, prohibiting a member firm or broker from offering private placements in cases of misrepresentations and omissions made to customers, or prohibiting penny stock liquidations in cases involving violations of the penny stock rules. A condition could also include posting a bond to cover harm to customers before the sanction imposed becomes final or precluding a broker from acting in a specified capacity. The conditions and restrictions would be tailored to the specific risks posed by the member firm or broker during the appeal period.

Unlike sanctions imposed in the Hearing Panel or Hearing Officer decision, the proposal would amend FINRA Rule 9311 (Appeal by Any Party; Cross-Appeal) to expressly state that the conditions and restrictions imposed by the Hearing Panel or Hearing Officer would not be stayed during the pendency of the appeal to the NAC. The interim order of conditions and restrictions would remain effective and enforceable until issuance of the NAC’s decision in the matter.

FINRA believes authorizing the Hearing Panel or Hearing Officer to order conditions and restrictions during an appeal would allow FINRA to target the demonstrated bad conduct of a respondent during the pendency of the appeal to the NAC. In addition, the proposal would amend FINRA Rule 9556 to grant FINRA staff the authority to start an expedited proceeding in accordance with Rule 9556 if a respondent failed to abide by the conditions and restrictions ordered.15

00 Expedited Review

Proposed Rule 9285(b) would establish an expedited review process to allow a respondent that has conditions or restrictions imposed by a Hearing Panel or Hearing Officer to file a motion with the Review Subcommittee of the NAC to modify or remove any or all of the restrictions.

Specifically, proposed Rule 9285(b)(1) would establish an expedited review process available to a respondent that has conditions or restrictions imposed by a Hearing Panel or Hearing Officer to file a motion with the Review Subcommittee of the NAC to modify or remove any or all of the restrictions. Proposed Rule 9285(b)(2) would provide that the respondent has the burden to show that the Hearing Panel or Hearing Officer committed an error by ordering the condition or restrictions imposed. The respondent must show that the conditions or restrictions are not reasonably necessary for the purpose of preventing customer harm. The respondent’s motion to modify or remove conditions or restrictions must be filed with FINRA’s Office of General Counsel and served simultaneously on OHO and all other parties to the disciplinary proceedings.

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Proposed Rule 9285(b)(3) would give FINRA’s Department of Enforcement five days from service of the respondent’s motion to file an opposition to the motion. As proposed, unless ordered otherwise by the Review Subcommittee, the motion to modify or remove conditions or restrictions would be decided based on the moving and opposition papers and would be decided in an expeditious manner and no later than 30 days after the filing of the opposition.

Proposed Rule 9285(b)(4) would provide that the filing of such an expedited motion to modify or remove a condition or restriction would stay the effectiveness of the ordered conditions and restrictions until the Review Subcommittee issues its ruling.

00 Mandatory Heightened Supervision

Proposed Rule 9285(c) would require any firm with which a respondent is associated to adopt a written plan of heightened supervision if any party appeals a Hearing Panel or Hearing Officer decision to the NAC, or if the NAC calls the case for review.16 The proposed amendments would require a firm to adopt a plan of heightened supervision regarding such respondents within ten days of filing an appeal, and this requirement would need to take into account any conditions or restrictions imposed by the Hearing Panel or Hearing Officer.

Specifically, when a Hearing Panel or Hearing Officer issues a decision pursuant to Rule 9268 or Rule 9269 in which the adjudicator finds that an associated person, the respondent, has violated a statute or rule provision, the proposed rule would require any firm with which the respondent is associated to adopt a written plan of heightened supervision that must remain in place until FINRA’s final decision takes effect.17 The member firm would be required to submit the written plan of heightened supervision within ten days of any party filing an appeal or the case being called for review by filing a copy of the plan of heightened supervision with FINRA’s Office of General Counsel and serving a copy on the Department of Enforcement. If a respondent becomes associated with another firm while the Hearing Panel’s or Hearing Officer’s decision is on appeal to the NAC, that member firm must file a copy of a plan of heightened supervision, taking into account any conditions or restrictions imposed by the Hearing Panel or Hearing Officer, with the Office of General Counsel and serve a copy on the Department of Enforcement within ten days of the respondent becoming associated with the firm.

The proposed rule would require a member firm to implement tailored supervisory procedures that are reasonably designed to prevent or detect a reoccurrence of the violations found by the Hearing Panel or Hearing Officer. In addition, the plan of heightened supervision must comply with Rule 3110, which requires firms to establish and maintain supervisory systems for each of their associated persons that are reasonably designed to achieve compliance with applicable securities laws and FINRA rules. The plan of heightened supervision must, at a minimum, include the designation

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of an appropriately registered principal who is responsible for carrying out the plan of heightened supervision. The plan of heightened supervision also must be signed by the designated principal, and include an acknowledgement that the principal is responsible for implementing and maintaining the plan of heightened supervision.

2. Proposed Amendments to the Rule 9520 Series (Eligibility Proceedings)

A. Overview of Current Statutory Disqualification Eligibility Process

Brokers who have engaged in the types of misconduct specified in the Exchange Act statutory disqualification provisions must undergo special review by FINRA before they are permitted to re-enter or continue working in the securities industry. In conducting its review, FINRA seeks to exclude brokers who pose a risk of recidivism from continuing in the securities business, subject to the limits developed in SEC case law.

As a general framework, the Exchange Act sets out the types of misconduct that presumptively exclude brokers from engaging in the securities business, identified as statutory disqualifications or SDs.18 These SDs are the result of actions against a broker taken by a regulator or court based on a finding of serious misconduct that calls into question the integrity of the broker, and include any felony and certain misdemeanors for a period of ten years from the date of conviction; expulsions or bars (and current suspensions) from membership or participation in a self-regulatory organization; bars (and current suspensions) ordered by the SEC, Commodity Futures Trading Commission, or other appropriate regulatory agency or authority; willful violations of the federal securities and commodities laws or MSRB rules; and certain final orders of a state securities commission.

The Exchange Act and SEC rules thereunder establish a framework within which FINRA evaluates whether to allow individuals who are the subject of an SD to associate with a member firm.19 A member firm that seeks to employ or continue the employment of an individual who is the subject of an SD therefore files an application (SD Application) seeking approval from FINRA.20 FINRA Rule 9520 Series sets forth eligibility proceedings under which FINRA may allow a member, person associated with a member, potential member, or potential associated person subject to an SD to enter or remain in the securities industry.21 A firm’s SD Application is subject to careful scrutiny by FINRA to best ensure that the individual’s association with the member firm is subject to heightened supervision and is consistent with the public interest and the protection of investors. To determine whether the SD Application will be approved or denied, FINRA takes into account factors that include the nature and gravity of the disqualifying event; the length of time that has elapsed since the disqualifying event and any intervening misconduct occurring since; the regulatory history of the disqualified individual, the firm and individuals who will act as supervisors; and any proposed plan of supervision.22

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If FINRA recommends approval of the SD Application, the recommendation is submitted either directly to the SEC for its review or to the NAC and ultimately to the SEC for their reviews and approvals. If FINRA recommends disapproval of the SD Application, the member firm has the right to a hearing before a panel of the Statutory Disqualification Committee and the opportunity to demonstrate why the SD Application should be approved.23 If the NAC denies the SD Application, the member firm can appeal the decision to the SEC and the federal circuit courts.24

As part of an SD Application, a member firm will propose a written plan of heightened supervision to closely monitor the SD individual’s securities-related activities. A heightened supervisory plan must be acceptable to FINRA, and FINRA will reject any plan that is not specifically tailored to address the SD individual’s prior misconduct and to mitigate the risk of future misconduct. In this regard, FINRA’s primary consideration is a heightened supervisory plan carefully constructed to best ensure investor protection.

Despite the requirement of heightened supervision to receive approval of an SD Application, there is currently no explicit rule requirement that these SD individuals be placed on heightened supervision by their employing member firm during the pendency of the SD Application review.25

B. Proposed Amendments to Require Automatic Heightened Supervision During Review Period

FINRA is proposing to amend Rule 9523 (Acceptance of Member Regulation Recommendations and Supervisory Plans by Consent Pursuant to SEA Rule 19h-1) to require a member firm to immediately place an individual on an interim plan of heightened supervision once an SD Application is filed. The proposed amendments would delineate the circumstances under which an individual who is statutorily disqualified may remain associated with a FINRA member while FINRA is reviewing his or her SD Application.

As with proposed Rule 9285 that would require a plan of heightened supervision during an appeal of a disciplinary action, proposed amendments to Rule 9523 provides flexibility regarding the details of specific interim plans of heightened supervision. However, the proposal would provide that, in order for supervision over a disqualified individual to be reasonable under Rule 3110, the interim plan of heightened supervision must be tailored to the disqualified individual, and must take into account the nature of the disqualification, the nature of the firm’s business, the disqualified person’s current and proposed activities at the firm, and the qualifications of the supervisor. Every interim plan would be required to identify a qualified principal responsible for carrying out such plan who has evidenced his or her acknowledgement of such responsibility by signing such plan.

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The proposed amendments would require that a copy of the interim plan of heightened supervision be submitted with the SD Application, and that the plan be in effect throughout the entire SD Application review process. The proposal would also make clear that an interim plan of heightened supervision may be modified by FINRA through the SD eligibility proceeding, that compliance with the interim plan of heightened supervision will be monitored through FINRA’s examination program, and that the firm or individual could be subject to further disciplinary proceedings for failure to comply with the interim plan. The proposed amendments also would provide that an SD Application may be determined to be substantially incomplete if the interim plan is not reasonably designed in compliance with the standards of the proposed amendments. If the applicant fails to timely remedy a substantially incomplete SD Application, FINRA will provide written notice to the member that the SD Application has been rejected, its reasons for so doing, and refund the application fee, less $1,000 as a FINRA processing fee. Upon such rejection, the SD Application is terminated and the member firm must promptly disassociate with the individual. FINRA would generally cover compliance with interim plans of heightened supervision as part of its examination program.

3. Proposed Amendments to Rule 8312 (FINRA BrokerCheck Disclosure)

Rule 8312 governs the information FINRA releases to the public through its BrokerCheck system.26 BrokerCheck helps investors make informed choices about the brokers and member firms with which they conduct business by providing extensive registration and disciplinary history to investors at no charge. FINRA has required member firms to inform their customers of the availability of BrokerCheck.27

FINRA is proposing to amend Rule 8312 to disclose the status of a member firm as a “taping firm” under Rule 3170 (Tape Recording of Registered Persons by Certain Firms)28 through BrokerCheck. Rule 3170 is designed to ensure that member firms with a significant number of registered persons that previously were employed by “disciplined firms” have specific supervisory procedures in place to prevent fraudulent and improper sales practices or other customer harm.29 Under the rule, a member that hires a specified percentage of registered persons from disciplined firms is designated as a “taping firm” and must establish, maintain, and enforce special written procedures for supervising the telemarketing activities of all its registered persons.30

A taping firm must adopt procedures that include tape-recording all telephone conversations between such firms’ registered persons and both existing and potential customers. Such firms also are required to review the tape recordings, maintain appropriate records, and file quarterly reports with FINRA.

To assist member firms in complying with Rule 3170, FINRA publishes on its website a “Disciplined Firms List” identifying those member firms that meet the definition of “disciplined firm.”31 A member firm that either is notified by FINRA or otherwise has actual knowledge that it is a taping firm is subject to the requirements of the rule.

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FINRA believes disclosing the status of a member firm as a taping firm through BrokerCheck will help inform investors of the heightened procedures required of the firm, which may incent the investors to research more carefully the background of a broker associated with the firm.

Currently, Rule 8312 provides that FINRA will release whether a particular member firm is a taping firm subject to Rule 3170 in response to telephonic inquiries via the BrokerCheck toll-free telephone listing. To better inform investors, the proposed amendment would permit FINRA to release information through BrokerCheck, in general, as to whether a particular member is subject to the provisions of Rule 3170.

4. Proposed Amendments to the NASD Rule 1010 Series (MAP Rules)

A. Current MAP Process

FINRA also seeks to prevent member firm recidivism by reviewing new member applications or membership changes pursuant to the NASD Rule 1010 Series.

Rule 1014(a) (Standards for Admission) sets forth the 14 standards for admission applied by FINRA’s Department of Member Regulation, through the MAP Group (collectively, the Department) in determining whether to approve a New Member Application (NMA) or a Continuing Member Application (CMA). The MAP rules require an applicant to demonstrate its ability to comply with the federal securities laws and FINRA rules, including observing high standards of commercial honor and just and equitable principles of trade applicable to its business. The Department evaluates an applicant’s financial, operational, supervisory and compliance systems to ensure that each applicant meets these standards for admission. The Department considers whether persons associated with an applicant have material disciplinary actions taken against them by other industry authorities, customer complaints, adverse arbitrations, pending or unadjudicated matters, civil actions, remedial actions imposed or other industry-related matters that could pose a threat to public investors.

In addition, Rule 1017 provides, among other things, that a member shall file a CMA when there are certain changes in ownership, control or business operations.32 IM-1011-1 creates a safe harbor for specified changes that are presumed not to be a “material change in business operations” and, therefore, do not require a member to file a CMA for approval of the change. One such change is an increase in the number of associated persons involved in sales within the parameters prescribed in the safe harbor. FINRA is concerned about instances where a member may onboard high-risk associated persons without prior consultation or review by FINRA.

Currently the materiality consultation process is used when a member contemplates a change in business operations that may not squarely fall within one of the categories or definitions that would require a CMA under Rule 1017 and the member firm seeks

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guidance to determine how best to proceed with the proposed change by voluntarily seeking a materiality consultation from the Department. A request for a materiality consultation is a written request from a member firm for a determination from the Department of whether a proposed change is material. There is no fee associated with submitting this request to the Department. The characterization of a proposed change as material depends on an assessment of all the relevant facts and circumstances. The Department may communicate with the member firm to obtain further information regarding the proposed change and its anticipated impact on the member firm. Where the Department determines that a proposed change is material, the Department will instruct the member to file a CMA if it intends to proceed and will advise that effecting the change without approval would constitute a violation of NASD Rule 1017.

B. Proposed Amendments to MAP Rules

FINRA is proposing amendments to the MAP rules to impose additional obligations on member firms that associate with persons who have, in the prior five years, either one or more final criminal matters, or two or more specified risk events. The proposed amendments to the MAP rules would allow FINRA to review and potentially restrict or deny a member firm from allowing such a person to become an owner, control person, principal or registered person. FINRA believes the proposed MAP rules would further promote investor protection by applying stronger standards for continuing membership with FINRA and for changes to a current member firm’s ownership, control or business operations.

00 Materiality Consultation

Proposed IM-1011-2 (Business Expansions and Persons with Specified Risk Events) would require an existing member firm to submit a written letter seeking a materiality consultation to the Department, if the member is not otherwise required to file a CMA, when a natural person that has, in the prior five years, one or more final criminal matters or two or more specified risk events seeks to become an owner, control person, principal or registered person of the member.

In addition, the proposed rule would expressly state that the safe harbor for business expansion in IM-1011-1 (Safe Harbor for Business Expansions) would not be available to member firms in this circumstance.

The proposed rule would provide that the member may not effect the contemplated activity until the member has first submitted a written letter to the Department seeking a materiality consultation for the contemplated activity, and would require that the letter address the issues that are central to the materiality consultation, in a manner prescribed by FINRA. The Department would consider the letter and other information or documents and determine in the public interest and the protection of investors that either (1) the member is not required to file a CMA in accordance with

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Rule 1017 and may effect the contemplated activity; or (2) the member is required to file a CMA in accordance with Rule 1017 and the member may not effect the contemplated activity, unless the Department approves the CMA.

In this regard, the materiality consultation would focus on, and the submitting member firm would need to provide information relating to, the conduct underlying the specified risk events, as well as other matters relating to the subject person such as disciplinary actions taken by FINRA or other industry authorities, adverse examination findings, customer complaints, pending or unadjudicated matters, terminations for cause or other incidents that could pose a threat to public investors. The Department’s assessment would factor in, among other things, whether the events are customer-related; represent discrete actions or are based on the same underlying conduct; the anticipated activities of the person; the disciplinary history, experience and background of the proposed supervisor, if applicable; the disciplinary history, supervisory practices, standards, systems and internal controls of the member firm and whether they are reasonably designed to achieve compliance with applicable securities laws and regulations, and FINRA rules; whether the member firm employs or intends to employ in any capacity multiple persons with one or more final criminal matters or two or more specified risk events in the prior five years; and any other impact on investor protection raised by seeking to make the person an owner, control person, principal or registered person of the member firm.

00 Definitions

The proposal would amend Rule 1011 to define a “final criminal matter” as a criminal matter that resulted in a conviction of, or guilty plea or nolo contendere (no contest) by, a person that is disclosed, or was required to be disclosed, on the applicable Uniform Registration Forms.33

The proposal would further amend Rule 1011 to define a “specified risk event” as any one of the following events that are disclosed, or are or were required to be disclosed, on the applicable Uniform Registration Forms:

i. a final investment-related,34 consumer-initiated customer arbitration award or civil judgment against the person for a dollar amount at or above $15,000 in which the person was a named party;

ii. a final investment-related, consumer-initiated customer arbitration settlement or civil litigation settlement for a dollar amount at or above $15,000 in which the person was a named party;

iii. a final investment-related civil action where the total monetary sanctions (including civil and administrative penalties or fines, disgorgement, monetary penalties other than fines, or restitution) were ordered for a dollar amount at or above $15,000; and

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iv. a final regulatory action where (A) the total monetary sanctions (including civil and administrative penalties or fines, disgorgement, monetary penalties other than fines, or restitution) were ordered for a dollar amount at or above $15,000; or (B) the sanction against the person was a bar (permanently or temporarily), expulsion, rescission, revocation or suspension from associating with a member.

As noted above, the proposed additional MAP obligations would apply only where the person has, within the prior five years, one or more final criminal matters or two or more specified risk events, and seeks to become an owner, control person, principal or registered person of the member firm.35

Economic Impact Assessment1. Regulatory Need

As discussed above, FINRA continually strives to strengthen its oversight of the brokers and firms it regulates in order to further its mission of protecting investors and market integrity, including protecting investors from brokers with a history of significant past misconduct and the firms that choose to employ them. Moreover, recent studies provide evidence of the predictability of future regulatory-related events for brokers with a history of past regulatory-related events such as repeated disciplinary actions, arbitrations and customer complaints.36 Therefore, notwithstanding the extensive protections afforded by the federal securities laws and FINRA rules, investors may reasonably continue to be concerned that without additional protections, the risk of potential customer harm may continue where these patterns exist. The proposals discussed in this Notice are designed to further promote investor protection by mitigating these concerns while recognizing the need to preserve principles of fairness.

2. Economic Baseline

The following provides the economic baseline for each of the current proposals. These baselines serve as the primary points of comparison for assessing economic impacts, including incremental benefits and costs of the proposed rule amendments. For this proposal, FINRA reviewed and analyzed relevant data over the 2013-2016 period (review period).

A. Proposed Amendments to the Rule 9200 Series and Rule 9300 Series

The economic baseline used to evaluate the economic impacts of the proposed rule changes to the Rule 9200 Series and Rule 9300 Series is the current regulatory framework under these rules. FINRA analyzed disciplinary matters that were appealed to the NAC over the review period that reached a final decision by the NAC.37 During the review period, there were approximately 18 such appeals filed each year, of which approximately 82 percent were filed by brokers, 8 percent were filed by firms, and the remaining 10 percent were filed jointly by brokers and firms.38 FINRA determined that, on average, these disciplinary decisions were on appeal for approximately 14 months.39

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B. Proposed Amendments to the Rule 9520 Series

The economic baseline used to evaluate the economic impacts of the proposed rule changes to the Rule 9520 Series is the current regulatory framework under these rules. FINRA analyzed SD Applications filed during the review period and determined that there were 122 SD Applications filed for 119 individuals by 105 firms, or approximately 31 requests that were filed by 26 firms each year.40 Approximately 54 percent of these applications were associated with small firms, 17 percent with mid-sized firms and 29 percent with large firms.41 FINRA also examined the resolution of these applications and determined that approximately 21 percent of the SD Applications were approved, 8 percent were denied, 9 percent were pending during the review period, and the remaining applications (62 percent) did not require a resolution because the SD individual’s registration with the filing firm was terminated or the SD Application was subsequently withdrawn.42 FINRA determined that, on average, the processing time for an SD Application that reached a final resolution (i.e., an approval or a denial) was approximately 10 months.43

C. Proposed Amendments to the BrokerCheck Rule

The economic baseline used to evaluate the economic impacts of the proposed rule changes to the BrokerCheck Rule is the current regulatory framework under Rules 8312 and 3170. During the review period, FINRA determined that 13 firms hired or retained enough registered persons from previously disciplined firms to be designated as a “taping firm” under Rule 3170 and were notified about their status during this period. All of these firms were small firms with the average size of approximately 40 registered persons. Of these 13 firms, nine firms did not become subject to the rule’s tape-recording requirements because they either took advantage of the one-time opportunity to reduce the number of their registered persons from previously disciplined firms below the specified thresholds or terminated their FINRA membership, and one firm was exempted from the requirements of the rule pursuant to Rule 3170(d). As a result, only three of the 13 firms designated as “taping firms” during the review period became subject to the requirements of Rule 3170.

D. Proposed Amendments to the MAP Rules

The economic baseline used to evaluate the economic impacts of the proposed rule changes to the MAP rules is the current regulatory framework under these rules. The proposed rule change would directly impact individuals with one or more final criminal matters or two or more specified risk events within the prior five years, who seek to become owners, control persons, principals or registered persons of a member firm. The criteria used for identifying individuals for this proposal and the number of individuals meeting the proposed criteria are discussed below.

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3. Economic Impacts

The following provides the economic impacts, including the anticipated benefits and the anticipated costs for each of the current proposals.

A. Proposed Amendments to the Rule 9200 Series and Rule 9300 Series

The proposed rule amendments would directly impact firms and brokers whose disciplinary matters are on appeal to the NAC. These impacts would vary across appeals and depend on, amongst other factors, the nature and severity of the conditions or restrictions imposed on the activities of respondents and the likely risk that they would continue to harm customers if permitted to remain working during the appeal period without those conditions or restrictions. As discussed above, the scope of these conditions or restrictions would depend on what the Hearing Panel determines to be reasonably necessary for the purpose of mitigating the risk of customer harm. Further, the conditions and restrictions would be tailored to the specific risks posed by the brokers or firms during the appeal period. Accordingly, the conditions and restrictions are not intended to rise to the level of the underlying sanctions and would likely not be economically equivalent to imposing the sanctions during the appeal.

The primary benefit of this proposal accrues from limiting the potential risk of continued harm to customers by respondents during the appeal period by imposing conditions or restrictions on their activities as well as imposing mandatory heightened supervision of brokers while their disciplinary matter is on appeal. In order to evaluate these benefits and assess the potential risk posed by brokers during the appeal period, FINRA examined cases that were appealed to the NAC during the review period and determined whether the brokers associated with an appeal to the NAC had a disclosure event at any time from the filing of the appeal through 2016. Specifically, FINRA identified brokers that were associated with one or more final criminal matters or specified risk events, as defined above, that occurred after they filed their appeals to the NAC.44 Based on this analysis, FINRA estimates that 16 of the 65 brokers who appealed to the NAC were associated with a total of 21 disclosure events that occurred subsequent to the filing of their appeal to the NAC.45 FINRA anticipates that the proposed heightened supervision requirement and the conditions or restrictions placed on the activities of these brokers would lead to greater oversight of their activities by their firm during the appeal period, thereby reducing the potential risk of future customer harm during this period.

The cost of this proposal would primarily fall upon brokers or firms whose activities during the appeal period would be subject to the specific conditions or restrictions imposed by the Hearing Panel. In addition, firms would incur costs associated with implementing heightened supervision for brokers while their disciplinary matters are under appeal. These costs would likely vary significantly across firms and could escalate if the broker acts in a principal capacity. For example, firms employing

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brokers that serve as principals, executive management, owners, or operate in other senior capacities would likely take on more costs in developing and implementing tailored supervisory plans. Such plans may entail re-assignments of responsibilities, restructuring within senior management and leadership, and more complex oversight and governance approaches. These potential costs, in turn, may result in some brokers voluntarily leaving the industry rather than waiting for the resolution of the appeal process.46

The costs associated with this proposal would apply to brokers and their employing firms only while the brokers are employed during the pendency of the NAC appeals. While the disciplinary decisions are on appeal for approximately 14 months on average, many brokers filing an appeal to the NAC are not employed at the time the appeal is filed or leave shortly after the appeal is filed. FINRA examined the employment history, including the employment start and end dates, of the 65 brokers associated with NAC appeals during the review period, and estimates that 31 (or 48 percent) of these brokers were not employed by any member firm at any point during the appeal process, 14 (or 21 percent) of the brokers were employed by a member firm only for part of the appeal process, and the remaining 20 (or 31 percent) of the brokers were employed by a member firm throughout the appeal process.

In developing the proposal, FINRA considered the possibility that, in some cases, this proposal may limit activities of brokers and firms, while their disciplinary matter is under appeal, in instances where the restricted activities do not pose a risk to customers. In such cases, these brokers and firms may lose economic opportunities and their customers may lose the benefits associated with the provision of these services. FINRA believes that the proposed rule changes mitigate such risks by requiring the conditions or restrictions imposed to be reasonably necessary for the purpose of reducing the potential risk of future customer harm and by providing a respondent with the right to seek to modify or remove any or all of the conditions and restrictions in an expedited proceeding. Further, as discussed above, only 31 percent of the brokers associated with NAC appeals were employed by a member firm for the full duration of their appeals. Approximately 69 percent of the brokers were not employed by a member firm at any time during the appeal process or were employed by a member firm only for part of the appeal process. Accordingly, these brokers would not be impacted by this proposal or would be subject to the proposed limitations only for a limited period of time.

B. Proposed Amendments to the Rule 9520 Series

The proposed rule amendments would impact SD individuals and their firms while the SD Application goes through an eligibility proceeding. The primary benefit of this proposed rule change would arise from greater oversight by firms of the activities of SD individuals during the pendency of their SD Applications. In order to assess the

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potential risk posed by these individuals during the pendency of their SD Applications, FINRA examined whether individuals associated with an SD Application filed during the review period had a disclosure event at any time from the filing of the application through 2016. Based on this analysis, FINRA estimates that 18 (or 15 percent) of the 119 individuals that filed SD Applications during the review period were associated with a total of 20 disclosure events subsequent to the filing of their SD Application.47 FINRA anticipates that the proposed heightened supervision requirement would lead to greater oversight by firms of the activities of these individuals during the pendency of their SD Application, thereby reducing the potential risk of customer harm during this period.

Firms may incur costs associated with implementing a tailored heightened supervision program for these individuals while their SD Application is under review. As discussed above, the costs would likely vary significantly across firms and could escalate if the SD individuals also serve as principals, executive management, owners or operate in other senior capacities. Moreover, the heightened supervision requirement may deter some firms from filing an SD Application for these individuals who, as a result, may find it more difficult to remain in the industry.

C. Proposed Amendments to the BrokerCheck Rule

The proposed amendments would impact taping firms and their registered persons. Taping firms have a proportionately significant number of registered persons that were associated with firms that were expelled by a self-regulatory organization or had their registration revoked by the SEC for sales practice violations, and as a result, may pose greater risk to their customers. Disclosing a firm’s status as a “taping firm” through BrokerCheck would help investors make more informed choices about the brokers and firms with which they conduct business. This proposal to disclose a firm’s status as a “taping firm” would not impose any direct costs on brokers or firms. Nonetheless it may impact their businesses, as investors may also rely on this information in determining whom to engage for financial services and brokerage activities. Disclosing the status of a firm as a “taping firm” through BrokerCheck may also further deter firms from hiring or retaining brokers that previously were employed by disciplined firms in order to avoid the “taping firm” disclosure on BrokerCheck.

D. Proposed Amendments to MAP Rules

The primary benefit of the proposed amendments would be to reduce the potential risk of future customer harm by individuals who meet the proposed criteria and seek to become an owner, control person, principal, or registered person of a member firm. FINRA believes the proposed rule change would further promote investor protection by applying stronger standards for continuing membership with FINRA and for changes to a current member firm’s ownership, control or business operations. These benefits would primarily arise from changes in broker and firm behavior and increased scrutiny by FINRA of brokers who meet the proposed criteria during the review of the applications.

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The cost of these proposals would fall on the firms that seek to add owners, control persons, principals or registered persons who meet the proposed criteria. These firms would be directly impacted by the proposals through the requirement to seek a materiality consultation with FINRA and potential requirement to file a CMA. While there is no FINRA fee for seeking a materiality consultation, firms may incur internal costs or costs associated with engaging external experts in conjunction with the filing of a CMA if necessary. The requirement of a materiality consultation could result in delays to a firm’s ability to add owners, control persons, principals or registered persons who meet the proposed criteria. Based on its review of the materiality consultation, FINRA may require the firm to file a CMA and the firm may not effect the applicable activity until the CMA is approved. FINRA examined the time to process materiality consultations and determined that, on average, these consultations are completed within 8-10 days, although this time period could be longer depending on the complexity of the contemplated expansion or transaction. FINRA recognizes that these anticipated costs may deter some firms from hiring individuals meeting the proposed criteria, who as a result may find it difficult to remain in the industry or bear other labor market related costs.

To provide transparency regarding the application of this proposal, the proposed criteria is based on disclosure events required to be reported on the Uniform Registration Forms. These Uniform Registration Forms are generally available to firms and FINRA.48 Accordingly, firms, with a few exceptions, can identify the specific set of disclosure events that would count towards the proposed criteria and replicate the proposed thresholds using available data.49 In determining the proposed numeric threshold, FINRA considered three key factors: (1) the different types of reported disclosure events; (2) the counting criteria or number of reported events required to trigger the obligations; and (3) the time period over which the events are counted. In evaluating the proposed numeric threshold versus alternative criteria, significant attention was given to the impact of possible misidentification of individuals; specifically, the economic trade-off between including individuals who are less likely to subsequently pose risk of harm to customers, and not including individuals who are more likely to subsequently pose risk of harm to customers but do not meet the proposed numeric threshold. There are costs associated with both types of misidentifications. For example, subjecting individuals who are less likely to pose a risk to customers to the MAP process would impose additional costs on these individuals, their affiliated firms and customers. The proposed numerical threshold aims to appropriately balance these costs in the context of economic impacts associated with the proposed amendments to the MAP rules.

The proposal may create incentives for changes in behavior to avoid meeting the proposed threshold. For example, brokers and firms may be more likely to try to settle customer complaints or arbitrations below $15,000 so that their settlements do not

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count towards the proposed threshold.50 To the extent, if any, that customers also would be willing to settle for less, this change may reduce the compensation provided to customers. Brokers and firms also may consider underreporting the disclosure events in an effort to avoid the attendant costs. However, this potential impact is mitigated by the fact that many of the events are reported by FINRA or other regulators and any incorrect or missing reports can trigger regulatory action by FINRA. FINRA rules require firms to take appropriate steps to verify the accuracy and completeness of the information contained in the Uniform Registration Forms before they are filed. FINRA also has the ability to check for unreported events, particularly those that are reported in a separate public notice by a third party, such as the outcome of some civil proceedings.

FINRA recognizes that in some instances, firms may not be able to identify certain individuals with disclosure events that may seek to become owners, control persons, principals or registered persons of the firm. Similarly, firms may have less incentive to conduct appropriate due diligence on those individuals for whom firms may not have readily available disclosure history.51 Firms, in these instances, would however still be required to seek information on relevant disclosure events from those individuals who seek to become principals or otherwise act as registered persons of the firm as part of their employment and registration process and take reasonable steps (e.g., by conducting background checks) to verify the accuracy and completeness of the information provided by them. Nonetheless, FINRA recognizes that in some cases, even after conducting reasonable due diligence, firms may not have the required information to identify certain individuals that meet the proposed criteria, and these individuals may continue to pose risk of future investor harm to investors. FINRA believes that these risks are mitigated by its own examination risk programs that monitor and examine individuals for which there are concerns of ongoing misconduct or imminent risk of harm to investors. These programs identify high-risk individuals based on the analysis of data available to the firms as well as additional regulatory data available to FINRA.52

In developing this proposal, FINRA analyzed disclosure events reported on the Uniform Registration Forms for all individuals during the review period. For each year, FINRA evaluated the data and determined the approximate number of individuals who would have met the proposed numeric threshold of one or more final criminal matters or two or more specified risk events in the prior five years. Exhibit 1 shows the disclosure categories that FINRA considered and the subcategories that were used for identifying final criminal matters and specified risk events. The exhibit also shows the mapping of these disclosure categories to the underlying questions in the Uniform Registration Form U4.53 Exhibit 2 shows the corresponding mapping between these disclosure categories to the questions in the Uniform Registration Form BD.54 Exhibit 3 provides a breakdown of the disclosure categories for all individuals registered with FINRA

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in 2016.55 The exhibit illustrates the impact of refining subcategories of reported disclosure events and the impact of different numeric thresholds on the number of disclosure events and registered persons associated with these events.56 This analysis has led FINRA to initially propose the numeric threshold set forth in the current proposal.

The additional proposed obligations would only apply to individuals with one or more final criminal matters or two or more specified risk events within the prior five years who seek to become owners, control persons, principals or registered persons of a firm. Accordingly, FINRA examined registration information in order to identify all individuals that would have met the proposed criteria during the review period. Those identified serve as a reasonable estimate for the number of individuals who would have been directly impacted by this proposal had it been in place at the time they were seeking to become an owner, control person, principal or registered person of a firm. This analysis indicates that there were approximately 100 – 160 such individuals, per year, as shown in Exhibit 4. These individuals represent 0.09 percent – 0.14 percent of individuals who became owners, control persons, principals, or registered persons with a new member in any year during the review period.57

FINRA also analyzed firms that employed individuals who would be directly impacted by this proposal. The analysis shows that in each year over the review period, there were between 115 and 170 firms employing individuals meeting the proposed conditions. Approximately 50 percent of these firms were small, 13 percent were mid-sized and the remaining 37 percent were large firms.58 FINRA estimates that approximately 38 percent of the individuals meeting the proposed criteria were employed by small firms, 17 percent by mid-sized firms and 45 percent by large firms.

4. Alternatives Considered

FINRA recognizes that the design and implementation of the rule proposals may impose direct and indirect costs on a variety of stakeholders, including member firms, associated persons, regulators, investors and the public. Accordingly, in developing its rule proposals, FINRA seeks to identify ways to enhance the efficiency and effectiveness of the proposals while maintaining their regulatory objectives. FINRA seeks comment on potential alternatives to the proposed amendments in this Notice and why these alternatives may be more efficient or effective at addressing broker misconduct than the proposed amendments.

FINRA considered several alternatives to the numerical and categorical thresholds for identifying individuals that would be subject to the proposed MAP rules amendments. In determining the proposed threshold, FINRA focused significant attention on the economic trade-off between incorrect identification of individuals that may not subsequently pose risk of harm their customers, and not including individuals that may subsequently pose

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risk of harm to customers but do not meet the proposed numeric threshold. FINRA also considered three key factors: (1) the different types of reported disclosure events, (2) the counting criteria or number of reported events, and (3) the time period over which the events are counted. FINRA considered several alternatives for each of these three factors.

A. Alternatives Associated With the Types of Disclosure Events

In determining the different types of disclosure events, FINRA considered all categories of disclosures events reported on the Uniform Registration Forms, including the financial disclosures and the termination disclosures. FINRA decided to exclude financial disclosures because they include personal bankruptcies, civil bonds, or judgments and liens. While these events may be of interest to investors in evaluating whether or not to engage a broker, these types of events by themselves are not evidence of customer harm. FINRA also considered whether termination disclosures should be included as specified risk events. Termination disclosures include job separations after allegations against the brokers.59 FINRA notes that certain termination disclosures reflect conflicts of interest between the firm and the broker and, as a result, may not necessarily be indicative of misconduct. Further, the underlying allegations in the termination disclosures may result in other disclosure events, such as those associated with customer settlements or awards, regulatory actions or civil actions, which are already included in the proposed criteria. If so, the underlying customer harm conduct would be captured in the proposed criteria. As a result, FINRA did not include termination disclosures as specified risk events. Accordingly, FINRA considered the remaining five categories of disclosure events listed in Exhibit 1.

Within each disclosure category included in the proposed criteria, FINRA considered whether pending matters should be included or if the criteria should be restricted to final matters that have reached a resolution not in favor of the broker. Pending matters include disclosure events that may remain unresolved or subsequently get dismissed because they lack merit or suitable evidence. For example, customers may file complaints that are false or erroneous and such complaints may subsequently be withdrawn by the customers or get dismissed by firms or arbitrators. Accordingly, FINRA excluded pending matters from the proposed criteria because these events may not always be associated with customer harm or misconduct.60

Exhibit 1 shows the five categories of disclosure events that were considered and the subcategories that were included in the proposed criteria. For criminal matters, FINRA considered whether criminal charges that do not result in a conviction, or guilty plea or nolo contendere (no contest), should be included in the proposed criteria. These events correspond to criminal matters in which the associated charges were subsequently dismissed or withdrawn, and, as a result, are not necessarily evidence of misconduct. Accordingly, FINRA only included criminal convictions, including guilty plea or nolo contendere (no contest), in the proposed criteria.

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For customer settlements and awards, FINRA considered whether settlements and awards in which the broker was not “named” should be considered as a specified risk event. These “subject of” customer settlements and awards correspond to events where the customer initiates a claim against the firm and does not specifically name the broker, but the firm identifies the broker as required by the Uniform Registration Forms.61 In these cases, the broker is not party to the proceedings or settlement. There may be conflicts of interest between the firm and the broker such that the claim may be attributed to the broker without the ability of that broker to directly participate in the resolution. Accordingly, FINRA excluded “subject of” customer settlements and awards from the proposed criteria. FINRA recognizes that excluding these events may also undercount instances where the broker may have been responsible for the alleged customer harm.

For civil actions and regulatory actions, FINRA considered whether all sanctions associated with final matters should be included or certain less severe sanctions be excluded from the proposed criteria. Final regulatory action or civil action disclosures may be associated with a wide variety of activities, ranging from material customer harm to more technical rule violations, such as a failure to file in time or other events not directly related to customer harm. However, due to the way in which such information is currently reported, it is not straightforward to distinguish regulatory or civil actions associated with customer harm from other such actions.62 In the absence of a reliable way to identify regulatory and civil actions associated with customer harm, FINRA considered using a proxy of severity of the underlying sanctions as a way to exclude events that are likely not associated with material customer harm. Specifically, FINRA only included regulatory actions or civil actions that are associated with more severe sanctions, such as bars and suspensions or monetary sanctions above a de minimis dollar threshold of $15,000. FINRA notes that relying strictly on a proxy for severity would likely exclude certain regulatory actions or civil actions that are associated with customer harm.

FINRA also considered several alternative de minimis dollar thresholds used for identifying disclosure events that are included in the proposed criteria. For example, FINRA considered higher dollar thresholds of $25,000, $50,000 and $100,000 for customer settlements, customer awards, and monetary sanctions associated with regulatory actions and civil actions. A dollar threshold may capture a dimension of severity of the alleged customer harm. FINRA has established a de minimis dollar reporting threshold of $10,000 for complaints filed prior to 2009 and $15,000 afterwards. The reporting threshold may, however, be low and possibly include instances where the payment was made to end the complaint and minimize litigation costs. However, the dollar threshold does not account for the value of the customers’ account and there are likely cases where even low dollar amounts represent remuneration of a significant portion of customer investments. Accordingly, a dollar

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threshold may be both under-inclusive and over-inclusive, and as a result FINRA considered a range of alternative thresholds. Increasing the dollar threshold from $15,000 to $25,000, $50,000 and $100,000 for identifying individuals that would have met the proposed criteria would decrease the number of individuals impacted by this proposal from 100 – 160 individuals each year to approximately 90 – 155 individuals, 80 –145 individuals and 65 – 135 individuals each year, respectively, over the review period. Finally, FINRA notes that establishing a de minimis dollar threshold that is different from that for the current reporting requirements would likely create incentives for individuals and firms to keep future settlements below the dollar level that would trigger the restrictions.

B. Alternatives Associated With the Counting Criteria

FINRA considered a range of alternative criteria used for counting criminal matters or specified risk events for classifying individuals. For example, FINRA considered whether the counting criteria for final criminal matters should be two or more final criminal matters or one final criminal matter and another specified risk event. This alternative would effectively count final criminal matters the same way as other specified risk events. FINRA believes that final criminal matters are generally more directly tied to serious misconduct than some of the other specified risk events. Accordingly, FINRA believes that one final criminal matter, as defined by this proposal, by itself should be sufficient to trigger the proposed criteria.63 FINRA also considered alternative criteria for counting specified risk events. For example, FINRA considered decreasing the proposed threshold for counting specified risk events from two to one such event during the prior five-year period. This alternative would change the proposed criteria to one or more final criminal matters or one (instead of two) or more specified risk events during the prior five-year period. This approach would increase the number of individuals impacted by this proposal from 100 – 160 individuals to 360 – 620 individuals each year, over the review period. FINRA also considered increasing the proposed threshold for counting specified risk events from two to three such events, thereby changing the proposed criteria to one or more final criminal matter or three (instead of two) or more specified risk events during the prior five year period. This approach would decrease the number of individuals impacted by this proposal from approximately 100 – 160 individuals to 55 – 105 individuals each year, over the review period.

C. Alternatives Associated With the Time Period Over Which the Disclosure Events Are Counted

FINRA also considered alternative criteria for the time period over which final criminal matters and specified risk events are counted for classifying individuals. For example, FINRA considered whether final criminal matters or specified risk events should be counted over the individual’s entire reporting period or counted over a more recent period. Based on its experience, FINRA believes that events that are more than ten years ago do not necessarily pose the same level of possible future risk to customers as more

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recent events. Further, counting final criminal matters or specified risk events over an individual’s entire reporting period would imply that individuals with such events would be subject to the criteria for their entire career, even if they subsequently worked without being associated with any future events. Accordingly, FINRA decided only to include final criminal matters or specified risk events in the more recent period. In addition to the proposed criteria based on a five year period, FINRA considered a criteria that would count two (or more) specified risk events in individuals’ reported histories over a ten-year and a five-year period; specifically, the first specified risk event having resolved during the previous ten years and the second specified risk event resolved during the previous five years, or one or more final criminal matters having resolved in the prior five-year period. This approach would increase the number of individuals impacted by this proposal from 100 – 160 individuals to 115 – 200 individuals each year, over the review period.

Request for Comment FINRA requests comment on all aspects of the proposal, including specifically the proposed amendments to the MAP rules. FINRA requests that commenters provide empirical data or other factual support for their comments wherever possible. FINRA specifically requests comment concerning the following issues.

1. How could current FINRA rules be amended to better address the problem(s) of broker misconduct? To what extent have the original purposes of and need for the rules been affected by subsequent changes to the markets, the delivery of financial services, the applicable regulatory framework, or other considerations?

2. What have been your experiences with current FINRA rules, including specifically Rule 3110 (Supervision), including any ambiguities in the rules or challenges to effectively address the problem(s) of broker misconduct?

3. Are there alternative ways to address broker misconduct that should be considered? What are the alternative approaches, other than the proposal, that FINRA should consider?

4. Are there any material economic impacts, including costs and benefits, to investors, issuers and firms that are associated specifically with the proposal? If so:

a. What are these economic impacts and what are their primary sources?

b. To what extent would these economic impacts differ by business attributes, such as size of the firm or differences in business models?

c. What would be the magnitude of these impacts, including costs and benefits?

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5. Are there any expected economic impacts associated with the proposal not discussed in this Notice? What are they and what are the estimates of those impacts?

6. As discussed above, FINRA considered several numerical and categorical thresholds for identifying individuals that would be subject to the proposed MAP rules amendments. In determining the proposed threshold, FINRA paid significant attention to the economic trade-offs associated with misidentifications, including both over- and under-identification of individuals. FINRA specifically seeks comments on the proposed numerical threshold, including (1) the different types of reported disclosure events, (2) the counting criteria, and (3) the time period of which the events are counted:

a. Are there any other types of disclosure events that FINRA should consider including in the proposed criteria? Which other disclosure events should FINRA consider including and how does including them improve the economic trade-offs associated with misidentifications?

i. What counting criteria should FINRA consider for counting these additional disclosure events? What time period should FINRA consider for counting these events?

b. Are there any reported disclosure events in Exhibit 1 that FINRA should consider excluding from the proposed criteria? Which events should FINRA consider excluding and how does excluding these events impact the economic trade-offs associated with misidentifications?

c. Should FINRA consider alternative counting criteria for the specified risk events or the final criminal matter? What are these alternative counting criteria and why are they a better alternative to the proposed counting criteria of one or more final criminal matters or two or more specified risk events?

d. Should FINRA consider alternative time periods over which one or more final criminal matters or two or more specified risk events are counted? Should FINRA consider using different time periods for criminal matters and specified risk events? Should FINRA consider different time periods for the four different types of specified risk events? What are these alternative approaches and why could they be better alternatives to the proposed period of prior five years?

7. As discussed above, the proposed MAP rules amendments would apply to individuals that meet the proposed criteria and seek to become an owner, control person, principal or registered person of a member firm. Should FINRA consider expanding the scope of the MAP requirements to:

a. all individuals who meet the proposed criteria and are currently owners, control persons, principals, or registered persons with a firm; or

b. all individuals who meet the proposed criteria and are currently associated with a firm, irrespective of their registration type or ownership and control status?

What are the incremental economic impacts, including incremental costs and benefits associated with these alternatives and why are they better than the proposed requirements?

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8. Should FINRA consider expanding the scope of the proposed MAP rule amendments to individuals meeting the proposed numerical threshold who are already a principal and seek to add an additional principal registration with their existing firm?

9. FINRA is proposing to disclose information through BrokerCheck on the status of a firm as a “taping firm.” Should FINRA also consider disclosing information of a broker’s association with a “taping firm” through BrokerCheck?

In addition to comments responsive to these questions, FINRA invites comment on any other aspects of the rules that commenters wish to address. FINRA further requests any data or evidence in support of comments. While the purpose of this Notice is to obtain input as to whether or not the current rules are effective and efficient, FINRA also welcomes specific suggestions as to how the rules should be changed.

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Endnotes

1. TheUniformRegistrationFormsforfirmsandbrokersaretheUniformApplicationforBroker-DealerRegistration(FormBD),theUniformApplicationforSecuritiesIndustryRegistrationorTransfer(FormU4),theUniformTerminationNoticeforSecuritiesIndustryRegistration(FormU5)andtheUniformDisciplinaryActionReportingForm(FormU6).FirmshaveaccesstodisclosureeventsreportedontheFormU4,U5,andU6filingsforbrokerswhowerepreviouslyregisteredwiththesamefirmsorwithotherfirms.Firms,however,donotreadilyhaveavailabletothemdisclosureeventsforpersonswhowerenotpreviouslyregistered,includingcontrolaffiliates,thatarereportedonanotherfirm’sFormBD.FINRAwouldexpectfirmstotakereasonablestepstoobtaininformationonthedisciplinaryhistoryofnon-registeredindividualsthatmaybedisclosedonanotherfirm’sFormBDthroughforexample,questionnaires,certifications,andreasonablebackgroundchecksforthoseindividualsseekingtobecomeanowner,controlperson,principalorregisteredpersonofthefirm.

2. See Regulatory Notice 18-15(HeightenedSupervision,GuidanceonImplementingEffectiveHeightenedSupervisoryProceduresforAssociatedPersonsWithaHistoryofPastMisconduct(April2018)).

3. FINRAalsoexpectstofileaproposedrulechangetoamendScheduleAtotheFINRABy-Lawstoincreasecurrentapplicationfeesforindividuals,andimposenewapplicationfeesformemberfirms,subjecttoanSDthatareseekingapprovalbyFINRAtoenterorremaininthesecuritiesindustry.Inconnectionwithouron-goingeffortstoaddresshigh-riskbrokers,FINRAalsowillbepublishingrevisedSanctionGuidelinesshortly.

4. PersonssubmittingcommentsarecautionedthatFINRAdoesnotredactoreditpersonalidentifyinginformation,suchasnamesoremailaddresses,fromcommentsubmissions.Personsshouldsubmitonlyinformationthattheywishtomakepubliclyavailable.See Notice to Members 03-73(November2003)(OnlineAvailabilityofComments)formoreinformation.

5. See SEASection19andrulesthereunder.AfteraproposedrulechangeisfiledwiththeSEC,theproposedrulechangegenerallyispublishedforpubliccommentinthe Federal Register.CertainlimitedtypesofproposedrulechangestakeeffectuponfilingwiththeSEC.See SEASection19(b)(3)andSEARule19b-4.

6. See Individuals Barred by FINRA.Thelistisupdatedmonthly.

7. See General Information on FINRA’s Eligibility Requirements.

8. See supranote6.

9. See supra note2.

10. ThisNoticewillrefertobothaHearingPanelandExtendedHearingPanelcollectivelyas“HearingPanel”unlessotherwisenoted.TheHearingPanelischairedbytheassignedHearingOfficerwhoisanemployeeofOHO.TheChiefHearingOfficerappointstwoindustrypanelists,drawnprimarilyfromapoolofcurrentandformersecuritiesindustrymembersofFINRA’sDistrictCommittees,aswellasitsMarketRegulationCommittee,formermembersofFINRA’sNACandformerFINRAGovernors.TheNACisthenationalcommitteethatreviewsinitialdecisionsrenderedinFINRAdisciplinaryandmembershipproceedings.

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©2018. FINRA. All rights reserved. Regulatory Notices attempt to present information to readers in a format that is easily understandable. However, please be aware that, in case of any misunderstanding, the rule language prevails.

http://www.finra.org/industry/individuals-barred-finra-a

http://www.finra.org/industry/general-information-finras-eligibility-requirements

http://www.finra.org/industry/general-information-finras-eligibility-requirements

11. Ifarespondentfailstoanswerthecomplaint,orapartyfailstoappearatapre-hearingconference,orapartyfailstoappearatanyhearingthatthepartyisrequiredtoattend,theHearingOfficermayissueadefaultdecisioninaccordancewithRule9269.

12. See FINRARule9311(b),whichfurtherprovidesthatanappealwillnotstayadecision,orpartofadecision,thatimposesapermanentceaseanddesistorder.

13. AssuchtermsaredefinedinRule9120(Definitions).

14. See, e.g., CBOERule17.11(b)(“PendingeffectivenessofadecisionimposingasanctionontheRespondent,theBusinessConductCommitteemayimposesuchconditionsandrestrictionsontheactivitiesoftheRespondentastheCommitteeconsidersreasonablynecessaryfortheprotectionofinvestorsandtheExchange”);BATSRule8.11(“PendingeffectivenessofadecisionimposingapenaltyontheRespondent,theCRO,HearingPanelorcommitteeoftheBoard,asapplicable,mayimposesuchconditionsandrestrictionsontheactivitiesoftheRespondentashe,sheoritconsidersreasonablynecessaryfortheprotectionofinvestors,creditorsandtheExchange.”);CHXArticle12,Rule6(explainingthatsanctionsarestayedduringappealprocess“subject,however,tothepoweroftheHearingOfficertoimposesuchlimitationsontherespondentasarenecessaryordesirable,inthejudgmentoftheHearingOfficerfortheprotectionoftherespondent’scustomers,creditorsortheExchangeorforthemaintenanceofjustandequitableprinciplesoftrade”);NasdaqPHLXRule960.10(b)(“PendingeffectivenessofadecisionimposingsanctionsonaRespondent,theHearingPanelmayimposesuchconditionsand

restrictionsontheactivitiesonsuchRespondentwhichitfindstobenecessaryorappropriatefortheprotectionoftheinvestingpublic,members,memberorganizationsandtheExchangeanditssubsidiaries.”)

15. ProposedRule9556(a)(2)wouldpermitFINRAstafftoissueanoticetoarespondentstatingthatthefailuretocomplywiththeconditionsorrestrictionsimposedunderRule9285withinsevendaysofserviceofthenoticewillresultinasuspensionorcancellationofmembershiporasuspensionorbarfromassociatingwithanymember.ProposedRule9556(c)(2)wouldgovernthecontentofthenoticesimilartocurrentRule9556(c).

16. See FINRARule3110.TherulerequiresmemberfirmstoestablishandmaintainasystemtosupervisetheactivitiesofeachassociatedpersonthatisreasonablydesignedtoachievecompliancewithapplicablesecuritieslawsandFINRArules.Aneffectivesupervisorysystemplaysanessentialroleinthepreventionofsalesabuses,andthus,enhancesinvestorprotectionandmarketintegrity.Assuch,irrespectiveofwhetheramatterisonappealorunderreview,afirmshouldroutinelyevaluateitssupervisoryprocedurestoensuretheyareappropriatelytailoredforeachassociatedpersonandtakeintoconsideration,amongotherthings,theperson’sactivitiesandhistoryofindustryandregulatory-relatedincidents.FINRAandtheSEChaveemphasizedtheneedforheightenedsupervisionwhenamemberfirmassociateswithpersonswhohaveahistoryofindustryorregulatory-relatedincidents.

17. See supra note16.

18. SDsaredefinedinSection3(a)(39)oftheExchangeAct.

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19. See 15U.S.C.§78o-3(g)(2)(“Aregisteredsecuritiesassociationmay,andincasesinwhichtheCommission,byorder,directsasnecessaryorappropriateinthepublicinterestorfortheprotectionofinvestorsshall,denymembershiptoanyregisteredbrokerordealer,andbarfrombecomingassociatedwithamemberanyperson,whoissubjecttoastatutorydisqualification.”);see also ExchangeActRule19h-1.

20. See supranote7.

21. TheRule9520SeriesstemsfromSection3(a)(39)oftheExchangeAct,whichsetsforththedefinitionofSD.In2007,FINRAamendedthedefinitionofSDinitsBy-LawstoincorporatebyreferenceExchangeActSection3(a)(39).ThischangeincorporatedthreeadditionalSDcategories,includingwillfulviolationsofthefederalsecuritiesorcommoditieslaws,groundsforSDthatwereenactedbytheSarbanes-OxleyActof2002,andassociationswithcertainotherpersonssubjecttoSD.Asaresult,therewasanincreaseinthenumberofindividualssubjecttoSDpursuanttoFINRA’sBy-Laws,andbyderivation,anincreaseinthenumberofindividualsseekingFINRA’sapprovaltoenterorremaininthesecuritiesindustrydespitetheirstatusasadisqualifiedindividual.

22. FINRA’sreviewofmanySDapplicationsisgovernedbythestandardssetforthinPaul Edward Van Dusen,47S.E.C.668(1981)andArthur H. Ross,50S.E.C.1082(1992).Thesestandardsprovidethatinsituationswhereanindividual’smisconducthasalreadybeenaddressedbytheSECorFINRA,andcertainsanctionshavebeenimposedforsuchmisconduct,FINRAshouldnotconsidertheindividual’sunderlyingmisconductwhenitevaluatesanSDapplication.InVan Dusen,theSECstatedthatwhentheperiodoftimespecifiedinthesanctionhaspassed,intheabsenceof“newinformationreflectingadverselyon

[theapplicant’s]abilitytofunctioninhisproposedemploymentinamannerconsonantwiththepublicinterest,”itisinconsistentwiththeremedialpurposesoftheExchangeActandunfairtodenyanapplicationforre-entry.47S.E.C.at671.TheSECalsonotedin Van Dusen,however,thatanapplicant’sre-entryisnot“tobegrantedautomatically”aftertheexpirationofagiventimeperiod.Id.Instead,theSECinstructedFINRAtoconsiderotherfactors,suchas:(1)“othermisconductinwhichtheapplicantmayhaveengaged”;(2)“thenatureanddisciplinaryhistoryofaprospectiveemployer”;and(3)“thesupervisiontobeaccordedtheapplicant.” Id. Further,inRoss,theSECestablishedanarrowexceptiontotherulethatFINRAconfineitsanalysisto“newinformation.”50S.E.C.at1085.TheSECstatedthatFINRAcouldconsidertheconductunderlyingadisqualifyingorderifanapplicant’slatermisconductwassosimilarthatitformeda“significantpattern.”Id. n.10.

23. ThehearingpanelconsidersevidenceandothermattersintherecordandmakesawrittenrecommendationontheSDApplicationtotheStatutoryDisqualificationCommittee.See Rule9524(a)(10).TheStatutoryDisqualificationCommittee,inturn,recommendsadecisiontotheNAC,whichissuesawrittendecisiontothememberfirmthatfiledtheSDApplication.See Rule9524(b).

24. Approximately75percentoftheapplicationsfiledin2016thathavereachedaresolutionwereeitherdeniedbyFINRA,withdrawnbecausetheapplicantexpectedFINRAwouldrecommenddenialofitsapplicationorclosedastheSDapplicationwasnotrequiredbyoperationoflaw.Fortheother25percent,FINRAapprovalresultedfromlegalprinciples,includingthoseembodiedintheExchangeActandincaselaw,asnotedabove,whichlimitsFINRA’sdiscretiontodenyanapplication.

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25. But see Regulatory Notice 18-15(remindingmemberfirmsoftheirobligationtotailorthefirm’ssupervisorysystemstoaccountforbrokerswithahistoryofindustryorregulatory-relatedincidents,includingdisciplinaryactions).

26. See BrokerCheck.

27. See Rules2210(d)(8)and2267.

28. Rule3170(a)(5)(A)definesa“tapingfirm”tomean:

(i) Amemberwithatleastfivebutfewerthantenregisteredpersons,where40%ormoreofitsregisteredpersonshavebeenassociatedwithoneormoredisciplinedfirmsinaregisteredcapacitywithinthelastthreeyears;

(ii) Amemberwithatleasttenbutfewerthantwentyregisteredpersons,wherefourormoreofitsregisteredpersonshavebeenassociatedwithoneormoredisciplinedfirmsinaregisteredcapacitywithinthelastthreeyears;

(iii) Amemberwithatleasttwentyregisteredpersonswhere20%ormoreofitsregisteredpersonshavebeenassociatedwithoneormoredisciplinedfirmsinaregisteredcapacitywithinthelastthreeyears.

29. Rule3170(a)(2)definesa“disciplinedfirm”tomean:

(A) amemberthat,inconnectionwithsalespracticesinvolvingtheoffer,purchase,orsaleofanysecurity,hasbeenexpelledfrommembershiporparticipationinanysecuritiesindustryself-regulatoryorganizationorissubjecttoanorderoftheSECrevokingitsregistrationasabroker-dealer;

(B) afuturescommissionmerchantorintroducingbrokerthathasbeenformallychargedbyeithertheCommodityFuturesTradingCommissionoraregisteredfuturesassociationwithdeceptivetelemarketingpracticesorpromotionalmaterialrelatingtosecurityfutures,thosechargeshavebeenresolved,andthefuturescommissionmerchantorintroducingbrokerhasbeencloseddownandpermanentlybarredfromthefuturesindustryasaresultofthosecharges;or

(C) afuturescommissionmerchantorintroducingbrokerthat,inconnectionwithsalespracticesinvolvingtheoffer,purchase,orsaleofsecurityfuturesissubjecttoanorderoftheSECrevokingitsregistrationasabrokerordealer.

30. Rule3170providesmemberfirmsthattriggerapplicationofthetapingrequirementaone-timeopportunitytoadjusttheirstaffinglevelstofallbelowtheprescribedthresholdlevelsandthusavoidapplicationoftherule.

31. Therearecurrently11firmsidentifiedas“disciplinedfirms,”andonefirmisidentifiedasatapingfirmunderRule3170.

32. Specifically,suchchangesare(1)amergerofthememberwithanothermember,unlessbotharemembersoftheNewYorkStockExchange(NYSE)orthesurvivingentitywillcontinuetobeamemberoftheNYSE;(2)adirectorindirectacquisitionbythememberofanothermember,unlesstheacquiringmemberisamemberoftheNYSE;(3)directorindirectacquisitionsortransfersof25percentormoreintheaggregateofthemember’sassetsoranyasset,businessorlineofoperationthatgeneratesrevenuescomposing25percentormoreintheaggregateofthemember’searningsmeasuredonarolling

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https://brokercheck.finra.org/

36-monthbasis,unlessboththesellerandacquireraremembersoftheNYSE;(4)achangeintheequityownershiporpartnershipcapitalofthememberthatresultsinonepersonorentitydirectlyorindirectlyowningorcontrolling25percentormoreoftheequityorpartnershipcapital;or(5)amaterialchangeinbusinessoperationsasdefinedinRule1011(k).Theterm“materialchangeinbusinessoperations”includes,butisnotlimitedto:(1)removingormodifyingamembershipagreementrestriction;(2)marketmaking,underwritingoractingasadealerforthefirsttime;and(3)addingbusinessactivitiesthatrequireahigherminimumnetcapitalunderRule15c3-1oftheExchangeAct.

33. ProposedRule1011(p)woulddefinethe“UniformRegistrationForms,”tomeantheUniformApplicationforBroker-DealerRegistration(FormBD),theUniformApplicationforSecuritiesIndustryRegistrationorTransfer(FormU4),theUniformTerminationNoticeforSecuritiesIndustryRegistration(FormU5)andtheUniformDisciplinaryActionReportingForm(FormU6).

34. FormU4Explanation of Termsdefinestheterm“investment-related”aspertainingtosecurities,commodities,banking,insurance,orrealestate(including,butnotlimitedto,actingasorbeingassociatedwithabroker-dealer,issuer,investmentcompany,investmentadviser,futuressponsor,bank,orsavingsassociation).

35. TheproposedMAPrulesamendmentswouldapplytoindividualsthatmeettheproposedcriteriaandseektoobtaintheirfirstprincipalregistrationatoneoftheirexistingfirmsoratanewfirm.Itwouldnotapplytoindividualswhomeettheproposednumericalthresholdandarealreadyaprincipalbutseektoaddanadditionalprincipalregistrationwithoneoftheirexistingfirms.

36. Forexample,in2015theOfficeoftheChiefEconomist(OCE)publishedastudythatexaminedthepredictabilityofdisciplinaryandotherdisclosureeventsassociatedwithinvestorharmbasedonpastsimilarevents.TheOCEstudyshowedthatpastdisclosureevents,includingregulatoryactions,customercomplaints,arbitrationsandlitigationsofbrokershavesignificantpowertopredictinvestorharm.InasubsequentresearchpaperbyacademicsattheUniversityofChicagoandtheUniversityofMinnesota,theauthorspresentevidencethatsuggestsahigherrateofnewdisciplinaryandotherdisclosureeventsishighlycorrelatedwithpastdisciplinaryandotherdisclosureevents,asfarbackasnineyearsprior.See Qureshi&Sokobin,Do Investors Have Valuable Information About Brokers?(2015);MarkEganetal.,The Market for Financial Adviser Misconduct(2016).

37. ThisanalysisincludedallNACappealsfiledduringthereviewperiodthatreachedafinaldecisionbytheendof2017.TheanalysisincludesallNACdecisions,includingaffirmations,modificationsorreversalsofthefindingsinthedisciplinarymatters.Theanalysisexcludesappealsthatwerewithdrawnpriortotheresolutionoftheappealprocess.

38. FINRAfurtherestimatesthatapproximately94percentoftheappealsfiledbybrokersinvolvedonebrokerandtheremaining6percentinvolvedtwobrokers.Alltheappealsfiledbyfirmswereassociatedwithonefirm.

39. Themedianprocessingtimewasapproximately15months,whilethe25thandthe75thpercentileswereapproximately11monthsand18months,respectively.

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http://www.finra.org/sites/default/files/OCE-Working-Paper.pdf

http://www.finra.org/sites/default/files/OCE-Working-Paper.pdf

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2739170

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2739170

40. Threeofthese119individualswereassociatedwithmultipleSDApplicationsoverthereviewperiod.Approximately90percentofthefirmsfiledonerequestduringthereviewperiod,andtheremaining10percentfiledtwoormorerequests.

41. FINRAdefinesasmallfirmasamemberwithatleastoneandnomorethan150registeredpersons,amid-sizefirmasamemberwithatleast151andnomorethan499registeredpersons,andalargefirmasamemberwith500ormoreregisteredpersons.See FINRABy-Laws,ArticleI.

42. Inapproximately12percentoftheSDApplications,theapplicationwaswithdrawnbecausethedecisionleadingtothedisqualifyingeventwasoverturned,thustheindividualwasnolongersubjecttoanSDorthesanctionswerenolongerineffect.Inoneofthe122SDApplications,theresolutionoftheapplicationwassubsequentlyreversed.

43. Themedianprocessingtimewasapproximately9monthsandthe25thandthe75thpercentileswereapproximately3monthsand14months,respectively.

44. TobeconsistentwiththedefinitionsusedforclassifyingbrokersfortheproposedMAPrequirements,FINRAbaseditsanalysisontheoccurrenceofoneormorefinalcriminalmattersorspecifiedriskevents,asdefinedintheproposedamendmentstotheNASDRule1010Seriesdiscussedabove.

45. Theseestimatesarebasedonappealsfiledbybrokers,orjointlyfiledbybrokersandfirms,andexcludesappealsthatwerefiledonlybyfirms.Theseestimateslikelyunderrepresenttheoverallriskofcustomerharmposedbythesebrokersbecausetheyarebasedonaspecificsetofevents

andoutcomesusedforclassifyingbrokersfortheproposedamendmentstotheMAPrules.Inaddition,thesebrokershadotherdisclosureeventsaftertheirappealwasfiledandsomeoftheseothereventsmayalsobeassociatedwithriskofcustomerharm.

46. Theproposalmayalsoimposecostsonissuersinlimitedinstanceswhereafirmisenjoinedfromparticipatinginaprivateplacementandtheissuerisespeciallyreliantonthatfirm.Theprivateissuermayincursearchcoststofindareplacementfirmorindividualandincurotherdirectandindirectcostsassociatedwiththeoffering.

47. TheseestimatesarebasedonthedefinitionsforspecifiedriskeventsandfinalcriminalmattersusedfortheproposedtheMAPrequirements,andasresult,likelyunderrepresentstheoverallriskofcustomerharmposedbytheseSDindividuals.

48. FirmshaveaccesstodisclosureeventsreportedontheFormU4,U5andU6filingsforindividualswhowerepreviouslyregisteredwiththesamefirmsorwithotherfirms.Firmsdonot,however,readilyhaveavailabletothemdisclosureeventsforindividualswheresuchindividualswerenotpreviouslyregistered,includingcontrolaffiliates,orwhereinformationregardingsuchindividualsisreportedonanotherfirm’sFormBD


50. Theproposed$15,000thresholdforcustomersettlementcorrespondstothereportingthresholdfortheUniformRegistrationFormsandforthesettlementinformationtobedisplayedthroughBrokerCheck.Asaresult,brokersandfirmsalreadyhaveincentivestosettlebelowthe$15,000amount.Accordingly,FINRAdoesnotanticipatethattheproposeddollarthresholdwouldresultinamaterialchangeincustomersettlements.

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51. Forexample,FINRAusesdisclosureeventsreportedonFormBDacrossallfirmstoidentifydisclosurerecordsofnon-registeredcontrolaffiliates.

52. Forexample,asdiscussedabove,firmsdonothaveaccesstodisclosureeventsfornon-registeredcontrolaffiliatesatotherfirms.

53. TheUniformRegistrationFormsU5andU6havequestionssimilartoFormU4thatcanalsobemappedtothedisclosurescategoriesinExhibit1.

54. TheUniformRegistrationFormBDincludesinformationondisclosureseventsforindividualcontrolaffiliates,includingnon-registeredcontrolaffiliates,thatmaynothaveFormU4,U5orU6filings.FormBDistheprimarysourceofinformationondisclosureeventsfortheseunregisteredcontrolaffiliates.FormBDincludesinformationonfinalcriminalmattersandcertainspecifiedriskeventsassociatedwithregulatoryactionsandcivilactions,butdoesnotincludeinformationoncustomerawardsorsettlements.

55. Exhibit3doesnotincludeinformationonindividualsthatwerenotregisteredwithFINRAin2016.Thesenon-registeredindividualsmayincludenon-registeredassociatedpersons,includingnon-registeredcontrolaffiliates.

56. Exhibit3showsthenumberofcriminaldisclosuresanddisclosuresconsideredindevelopingspecifiedriskevents(regulatoryactiondisclosures,civiljudicialdisclosures,andcustomercomplaint,arbitrationandcivillitigationdisclosures),includingpendingandfinaldisclosures,overtheentirereportinghistoryofbrokerswhowereregisteredwithFINRAin2016.Theexhibitalsoreportsthenumberofbrokersassociatedwiththesedisclosureeventsandtheimpactofrefiningthedisclosurecategoriesandtheperiodover

whichtheseeventsarecounted.Forexample,theexhibitshowsthatthereareatotalofapproximately20,900criminaldisclosuresand140,200disclosuresconsideredindevelopingspecifiedriskeventsovertheentirereportinghistoryofthesebrokers.Refiningthedisclosurecategoriestoincludefinalcriminalmattersandspecifiedriskevents,asdefinedinthisproposal,wouldresultinapproximately155finalcriminalmattersand3,425specifiedriskevents.Exhibit3alsoshowsthattherewereapproximately490brokerswhowereregisteredwithFINRAin2016andmettheproposednumericthresholdofoneormorefinalcriminalmattersortwoormorespecifiedriskeventsinthepriorfiveyears.

57. ThesepercentagesarecalculatedbydividingFINRA’sestimateofthenumberofindividualswhomettheproposedcriteriaeachyearduringthereviewperiod(approximately100–160individualsperyear),bythenumberofindividualswhobecameowners,controlpersons,principals,orregisteredpersonswithanewmembereachyearduringthereviewperiod(approximately105,500–112,800individualsperyear).


59. Terminationdisclosuresinvolvesituationswheretheindividualvoluntarilyresigned,wasdischarged,orwaspermittedtoresignafterallegations.

60. Morethan50percentofthependingmattersduringthereviewperiodremainunresolvedorweresubsequentlydismissed.Forexample,Exhibit3showsthatapproximately69,000(or49percent)ofthe140,000disclosuresconsideredindevelopingspecifiedriskeventsresultedinfinalmatters.Accordingly,morethan50percentofthependingmattersremainunresolvedorweresubsequentlydismissedordidnotreacharesolutionthatwasunfavorabletothebroker.

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61. Forexample,theInstructionstoFormU4,Questions14I(4)or14I(5)providethattheanswershouldbe“yes”ifthebrokerwasnotnamedasarespondent/defendantbut(1)theStatementofClaimorComplaintspecificallymentionstheindividualbynameandallegesthebrokerwasinvolvedinoneormoresalespracticeviolationsor(2)theStatementofClaimorComplaintdoesnotmentionthebrokerbyname,butthefirmhasmadeagoodfaithdeterminationthatthesalespracticeviolation(s)allegedinvolvesoneormoreparticularbrokers.

62. Forexample,theUniformRegistrationFormscontainadescriptionontheallegation,whichcouldbeusefulinidentifyingregulatoryactionsorcivilactionsassociatedwithcustomerharm,butthisinformationisstoredas“free-text”and,therefore,cannotbereliablycomparedacrossdisclosures.

63. FINRArecognizesthatfinalcriminalmattersincludefelonyconvictionsthatmaynotbeinvestmentrelated(e.g.,aconvictionassociatedwithmultipleDUIs).

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April30,2018 18-16

Summary FINRA is publishing this Notice to reiterate the supervisory obligations of member firms regarding associated persons with a history of past misconduct that may pose a risk to investors. FINRA Rule 3110 (Supervision) requires member firms to establish and maintain a system to supervise the activities of each associated person that is reasonably designed to achieve compliance with applicable securities laws and FINRA rules. An effective supervisory system plays an essential role in the prevention of sales abuses, and thus, enhances investor protection and market integrity. As such, FINRA has long emphasized that member firms have a fundamental obligation to implement a supervisory system that is tailored specifically to the member firm’s business and addresses the activities of all its associated persons. This Notice highlights particular instances where heightened supervision of an associated person may be appropriate. Firms are encouraged to adopt the practices that are outlined in this Notice to strengthen their own supervisory procedures, as appropriate to their business.

This Notice is one of several FINRA initiatives focused on associated persons with a history of past misconduct that pose a risk to investors and the firms that employ them. These initiatives are designed to strengthen oversight of such associated persons and firms through a combination of guidance, rule changes, and FINRA examination and surveillance programs. FINRA also is simultaneously issuing Regulatory Notice 18-16 seeking comment on proposed rule amendments to further efforts to protect investors.1

Questions concerning this Notice should be directed to Kosha Dalal, Associate Vice President and Associate General Counsel, Office of General Counsel (OGC), at (202) 728-6903 or [email protected].

1


April 30, 2018

Notice Type 00 Guidance

Suggested Routing00 Compliance 00 Legal 00 Operations00 Registered Representatives00 Senior Management

Key Topics00 Heightened Supervision00 Supervision

Referenced Rules & Notices00 FINRA Rule 311000 Notice to Members 97-1900 Notice to Members 98-3800 Regulatory Notice 18-16

Heightened SupervisionGuidance on Implementing Effective Heightened Supervisory Procedures for Associated Persons With a History of Past Misconduct

mailto:[email protected]

Background & DiscussionFINRA administers comprehensive regulatory programs designed to help our members maintain trust in the financial markets. These programs serve multiple purposes in advancing FINRA’s mission of protecting investors and market integrity—including promoting compliance with applicable rules, creating a level playing field, and enhancing transparency and access to information. One of their most important purposes is to protect investors from bad actors: those who seek to evade regulatory requirements and harm investors for their own personal gain. FINRA continues to evaluate and augment its regulatory programs to better identify and supervise potential bad actors.

Member firms also have a key role to play in protecting investors from bad actors. While FINRA believes that the vast majority of registered representatives seek to serve their clients in accordance with all applicable regulatory requirements, ongoing vigilance by member firms is critical. Member firms should be reviewing and updating their supervisory systems and procedures for hiring practices, monitoring brokers and investigating red flags suggestive of misconduct. FINRA requires member firms to establish and maintain supervisory systems for each of their associated persons and to test and verify annually that they have established reasonable procedures, including procedures for heightened supervision of associated persons, where necessary. FINRA and the SEC have emphasized the need for heightened supervision when a member firm associates with persons who have a history of industry or regulatory-related incidents.2 These heightened supervisory procedures are a critical element in a member firm’s supervisory system. As such, it is essential that firms monitor the histories of their associated persons and establish heightened measures to supervise the activities of those associated persons with greater potential of creating customer harm.

FINRA previously issued guidance regarding the application of heightened supervisory plans for associated persons with a history of industry or regulatory-related incidents.3 For example, a firm that hires an associated person with a recent history of customer complaints, disciplinary actions involving sales practice abuse or other customer harm, or adverse arbitration decisions should determine whether it needs special supervisory procedures for that associated person, or whether its existing supervisory procedures are sufficient to address the circumstances.4 Firms also should make this determination where an associated person, during his or her employment with the firm, develops a history of problems.

Member firms often serve as the first line of defense against customer harm through establishing and maintaining effective supervisory systems, particularly with regard to associated persons who may pose higher risks of causing customer harm. In order to provide additional guidance to firms, FINRA has identified certain circumstances under which firms are encouraged to consider implementing heightened supervisory procedures for an associated person.5 Implementation of the suggested recommendations may

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help to reduce future customer harm by brokers; however, the recommendations below are not intended to be an exhaustive list of circumstances firms should consider when determining whether to implement heightened supervisory procedures. Moreover, a firm’s implementation of the recommendations in and of themselves would not necessarily satisfy its obligations under Rule 3110(a) to establish and maintain a supervisory system reasonably designed to achieve compliance with applicable securities laws and applicable FINRA rules or other obligations that may arise under FINRA rules.

Heightened Supervisory Procedures

A firm should routinely evaluate its supervisory procedures to ensure they are appropriately tailored for each associated person and take into consideration, among other things, the person’s activities and history of industry and regulatory-related incidents. When an associated person of the firm has a history of industry or regulatory-related incidents, the firm must make a reasonable determination as to whether its standard supervisory and educational programs are adequate to address the issues such person’s history raises or whether the firm should develop tailored heightened supervisory procedures to address such issues. The failure to assess the adequacy of its supervisory procedures in light of an associated person’s history of industry or regulatory-related incidents would be closely evaluated in determining whether the firm itself should be subject to disciplinary action for a failure to supervise should that person be the subject of a future industry or regulatory-related incident.

A. Identifying Individuals for Heightened Supervision

In identifying which associated persons to place on heightened supervision, firms should consider, among other things, customer-related regulatory actions; criminal matters; the firm’s pre-registration investigation; internal investigations; firm-imposed discipline; disciplinary actions; final, pending and settled arbitrations; past, open or settled customer complaints; terminations for cause; and other items disclosed on the person’s uniform registration forms.6 While final adverse adjudicated matters such as disciplinary actions, criminal matters and arbitrations clearly indicate a disciplinary problem, a pattern of unadjudicated matters, such as unadjudicated customer complaints, also may be indicative of a history that should be carefully reviewed.

In addition, FINRA believes that the following two circumstances raise significant investor protection concerns, and firms should evaluate the facts and circumstances to make a determination of whether heightened supervision would be appropriate.7

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April 30, 2018 18-15

00 Heightened Supervision of Statutorily Disqualified Persons During Eligibility Review Process

Currently, if an associated person who has an industry or regulatory-related event that qualifies as a statutory disqualification (SD) under the Securities Exchange Act of 1934 (Exchange Act) wants to continue associating with a member firm, he or she must undergo a FINRA eligibility proceeding.8 Under FINRA’s current rules, a person who becomes statutorily disqualified while associated with a member firm is allowed to remain associated with that member firm during FINRA’s review process, so long as the member firm promptly files a Form MC-400 application (SD Application). In reviewing an SD Application, FINRA can seek to prevent the statutorily disqualified person from associating with a member firm or can permit the statutorily disqualified person to associate with a member firm if it is consistent with the public interest and protection of investors. Generally, where FINRA permits the statutorily disqualified person to associate or continue association with a member firm, FINRA will condition the association on the establishment of certain safeguards, including the adoption and implementation of a heightened supervisory plan by the member firm of the person’s business activities. To further promote investor protection, member firms should consider adopting and implementing an interim plan of heightened supervision for any statutorily disqualified person associated with the firm once the SD Application is filed with FINRA and to keep such heightened supervisory plan in place while the review is pending. FINRA believes heightened supervision may be appropriate for such persons because they have already been statutorily disqualified, and, in nearly every case, the continued association of a statutorily disqualified person approved through a FINRA eligibility proceeding is conditioned on the individual being subject to a robust heightened supervision plan.

00 Heightened Supervision of Persons While Disciplinary Case Is On Appeal

Currently, when an associated person or member firm in a litigated disciplinary case appeals a Hearing Panel decision to the National Adjudicatory Council (NAC), sanctions are generally stayed pending an appeal.9 In cases where the Hearing Panel has rendered a decision making a finding of violation against the associated person and where an appeal is filed, to further promote investor protection, firms should consider adopting and implementing an interim plan of heightened supervision for such associated person and keep such heightened supervisory plan in place while the appeal is pending. FINRA believes heightened supervision may be appropriate for such persons because they have already been found to have violated a rule.

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B. Developing and Implementing a Heightened Supervision Plan

Once a firm determines that heightened supervision is necessary, the firm should develop written, tailored heightened supervisory procedures designed to address the nature of the particular concerns the associated person’s incident history raises and the nature of such person’s ongoing activities. When developing a heightened supervision plan, the firm should determine the parameters of the plan on a case-by-case basis for each associated person that the firm has identified as requiring heightened supervision.

In making this determination, a firm should consider whether the nature of the concerns the associated person’s incident history raises involved a particular product, customer type or activity. In any of these instances, the firm should examine the product, customer type or activity to identify the level and type of risk it presents. The firm should then determine what type of supervision might best control and limit this type of risk. The plan should reflect a firm’s reasonable consideration of how to effectively supervise the individual through tailored provisions designed to prevent and deter future incidents.

FINRA has provided a number of factors that firms should consider including in a heightened supervision plan. Firms are cautioned that these factors are neither exhaustive nor will they constitute a safe harbor for FINRA rules. Based on staff experience, FINRA believes effective heightened supervision plans should include, at a minimum:

00 designating a principal with the appropriate training and experience to implement and enforce the plan;

00 requiring appropriate additional training for the associated person subject to the plan to address the nature of incidents resulting in the plan;

00 requiring the written acknowledgment of the heightened supervisory plan by the associated person subject to the plan and the designated supervisory principal; and

00 periodically reviewing the heightened supervision plan to assess its effectiveness.

In addition to these minimum provisions, FINRA has seen, among other things, effective heightened supervision plans that provide for:

00 heightened supervision of the associated person’s business activities, including customer-related activities, employee personal trading accounts, outside business activities and private securities transactions;

00 proximity of the supervisor to the associated person;00 more frequent contact between the supervisor and the associated person;00 more frequent review of the associated person’s communications, particularly with

customers;00 more frequent monitoring or inspection of the associated person’s office(s); and00 expediting the handling of customer complaints related to the associated person.

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April 30, 2018 18-15

Endnotes

1. See Regulatory Notice 18-16(FINRARequestsCommentonFINRARuleAmendmentsRelatingtoHigh-RiskBrokersandtheFirmsthatEmployThem)(April2018).Inconnectionwithouron-goingeffortstoaddresshigh-riskbrokers,FINRAalsowillbepublishingrevisedSanctionGuidelinesshortly.

2. See, e.g., Dep’t of Enforcement v. J. Alexander Sec., Inc., No.CAF010021,2004NASDDiscip.LEXIS16,at*51(NACAug.16,2004), aff’d sub nom. Robert J. Prager,ExchangeActRel.No.51974,2005SECLEXIS1558(July6,2005);Signal Sec., Inc.,ExchangeActRel.No.43350,2000SECLEXIS2030,at*17(Sept.26,2000);James Harvey Thornton,53S.E.C.1210,1216(1999);Consolidated Inv. Serv., Inc.,52S.E.C.582,588-89(1996);Notice to Members 97-19(April1997);Notice to Members 98-39(May1998).

3. See Notice to Members 97-19(statingthatamemberfirmwitharegisteredrepresentativewhodevelopsahistoryofcustomercomplaints,finaldisciplinaryactionsinvolvingsalespracticeabuseorothercustomerharm,oradversearbitrationdecisionsshouldconsiderdevelopingspecialsupervisoryproceduresforthatregisteredrepresentative);and Notice to Members 98-39 (indicatingthatunexpectedsupervisoryvisitstoofficeswithpersonnelwhohavedisciplinaryrecordsmaybeappropriate).See also,RobertW.Cook,PresidentandCEO,FINRA,AddressattheMcDonoughSchoolofBusiness,GeorgetownUniversity:ProtectingInvestorsFromBadActors(June12,2017),available atwww.finra.org/newsroom/speeches/061217-protecting-investors-bad-actors;andFINRA2018RegulatoryandExaminationPrioritiesLetter(January8,2018),available at www.finra.org/industry/2018-regulatory-and-examination-priorities-letter.

A member firm’s supervisory system is critical to protecting investors and market integrity, particularly where persons associated with the firm have a history of industry or regulatory-related incidents. It is essential that firms monitor the regulatory histories of their associated persons and establish additional measures to supervise the activities of those individuals with greater potential of creating customer harm. The implementation of heightened supervision does not diminish the importance of a member firm’s overall supervisory obligations. Member firms must continue to have supervisory systems reasonably designed to ensure compliance with applicable securities laws and FINRA rules for each type of business conducted by the firm and its associated persons.

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http://www.finra.org/industry/2018-regulatory-and-examination-priorities-letter

http://www.finra.org/industry/2018-regulatory-and-examination-priorities-letter

4. See FINRARule3110(e),whichrequiresafirmtoascertainbyinvestigationthegoodcharacter,businessreputation,qualificationsandexperienceofanapplicantbeforeitregistersthatapplicantwithFINRA.Firmsareadvisedtoconsiderallavailableinformationgatheredinthepre-registrationprocessforthispurpose,includingFormU4andU5responses,searchesoftheCRDsystem,fingerprintresults,privatebackgroundchecksandcommunicationswithpreviousemployers.Inaddition,FINRAstrengthenedthebackgroundcheckobligationsoffirmsbyrequiringfirmstoadoptwrittenproceduresreasonablydesignedtoverifytheaccuracyofcompletenessoftheinformationcontainedintheapplicant’sFormU4.See also Notice to Members 97-19.

5. FINRAalsorequiresheightenedsupervisioninsomecaseswhenafirmhiresnumerousindividualsfromadisciplinedfirm.Insuchcases,afirmcanbecomea“tapingfirm,”andberequiredtotaperecordallofitsregisteredpersons’phonecallswithinvestors. See FINRARule3170(TapeRecordingofRegisteredPersonbyCertainFirms).

6. See theUniformApplicationforSecuritiesIndustryRegistrationorTransfer(FormU4),theUniformTerminationNoticeforSecuritiesIndustryRegistration(FormU5)andtheUniformDisciplinaryActionReportingForm(FormU6).

7. See Regulatory Notice 18-16(April2018),inwhichFINRAisseeking,amongotherthings,commentonproposalstorequiremandatoryheightenedsupervisioninthetwoinstancesdescribed.

8. Eventstriggeringstatutorydisqualificationinclude,forexample,certainenumeratedmisdemeanorandallfelonycriminalconvictionsforaperiodoftenyearsfromthedateofconviction;temporaryandpermanentinjunctions(regardlessoftheirage)involvingabroadrangeofunlawfulinvestmentactivities;bars(andcurrentsuspensions)orderedbytheSECoraself-regulatoryorganization(SRO);andfindingsthatapersonwillfullyhasmadeorcausedtobemadefalsestatementsofamaterialfacttoanSRO.See Sections3(a)(39)and15(b)(4)(A)oftheExchangeAct;FINRABy-LawsArticleIII,Section4.Personswhoareorbecomesubjecttoastatutorydisqualificationmayseektoenter,re-enter,orinthecaseofincumbents,continueinthesecuritiesindustry.

9. See FINRARule9311(b).

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April 30, 2018 18-15

SummaryVolatility-linked exchange-traded products (ETPs)1 are designed to track Chicago Board Options Exchange Volatility Index (VIX) futures, rather than the VIX itself. For the reasons explained further below, many volatility-linked ETPs are highly likely to lose value over time. Accordingly, volatility-linked ETPs may be unsuitable for certain retail investors, particularly those who plan to use them as traditional buy-and-hold investments.

This Notice reminds firms of their sales practice obligations in connection with volatility-linked ETPs as discussed more generally in Regulatory Notice 12-03, including, without limitation, that recommendations to customers must be based on a full understanding of the terms, features and risks of the product recommended, sales materials must be fair and accurate, and firms must have reasonable supervisory procedures in place to ensure that these obligations are met.

Questions concerning this Notice should be directed to:

00 Thomas M. Selman, Executive Vice President, Regulatory Policy, at (202) 728-6977 or by email at [email protected];

00 James S. Wrona, Vice President and Associate General Counsel, Office of General Counsel (OGC), at (202) 728-8270 or by email at [email protected]; or

00 Kathryn Moore, Associate General Counsel, OGC, at (202) 728-8200 or by email at [email protected].

1


October 2017

Notice Type 00 Guidance

Suggested Routing00 Advertising00 Compliance00 Legal00 Senior Management

Key Topics00 Communications with the Public00 Exchange-Traded Products00 Suitability00 Supervision00 Training00 Volatility-Linked Exchange-Traded Products

Reference Rules and Notices00 FINRA Rule 2111 00 FINRA Rule 221000 FINRA Rule 311000 Regulatory Notice 10-5100 Regulatory Notice 12-03

Volatility-Linked Exchange-Traded ProductsFINRA Reminds Firms of Sales Practice Obligations for Volatility-Linked Exchange-Traded Products


Background and Discussion The VIX is frequently cited as a measure of investor fear, which historically tends to be elevated in periods of market distress and lower under normal market conditions.2 The VIX often moves sharply higher when stock indices decline significantly. As such, the VIX has the desirable attribute that it is negatively correlated with the broader stock market.

Volatility-linked ETPs generally provide exposure to volatility by tracking short- and mid-term VIX futures indices.3 Volatility-linked ETPs that seek to maintain a continuous, targeted maturity exposure to VIX futures will either track or hold VIX futures contracts on a rolling basis, meaning that they will sell shorter-term contracts or contracts about to expire with contracts that have more distant or deferred maturity dates in order to maintain the desired exposure. Historically, the prices for VIX futures have tended to increase as the futures contract dates go out farther into the future, so the strategy of maintaining a targeted maturity exposure to VIX futures can often involve selling a contract with a lower price than the one bought to replace it. This rolling of contracts can result in a loss on the trade or a negative roll yield.4

Because of the negative roll yield, many volatility-linked ETPs that seek to maintain a continuous, targeted maturity exposure to VIX futures, particularly to shorter maturities, have lost a significant amount of value over time; some have lost more than 90 percent of their value since they launched. And, such products will likely continue to lose value over longer periods of time. Moreover, the performance of VIX futures can diverge from that of the VIX, and in general, movements in the futures are smaller in magnitude than those of the VIX. For these reasons, the performance of volatility-linked ETPs that seek to maintain a continuous, targeted maturity exposure to VIX futures may also be less correlated to that of the VIX than investors might expect.5

The risks of volatility-linked ETPs have been highlighted by both academic and financial publications6 and firms, registered representatives, their supervisors and investors should understand the risks of these products. Without understanding the key features of these volatility-linked ETPs, some investors and registered representatives could mistakenly believe that these products are likely to exhibit behavior similar to that of the VIX over short as well as long time horizons and thus provide protection against market losses over a variety of time periods. In fact, these products have not exhibited, and likely will not exhibit, behavior similar to the VIX over longer periods and exhibit imperfect correlation even over shorter periods.7

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Sales Practice Obligations Relating to Volatility-Linked ETPs As detailed in Regulatory Notice 12-03, products that offer retail investors exposure to stock market volatility, such as volatility-linked ETPs, are “complex” products. Firms should review that Notice and consider whether to use the type of heightened scrutiny and supervision suggested therein for these complex products.8 Firms are similarly reminded that they must comply with the obligations discussed below when offering volatility-linked ETPs.

Suitability FINRA Rule 2111 requires member firms and associated persons to have a reasonable basis to believe that a recommended transaction or investment strategy involving a security or securities is suitable for the customer, based on the information obtained through the reasonable diligence of the member or associated person to ascertain the customer’s investment profile. Two of the main suitability obligations delineated in Rule 2111 that are particularly relevant to volatility-linked ETPs are customer-specific and reasonable-basis suitability. The former requires a reasonable basis to believe that a recommendation is suitable for a particular customer based on the customer’s investment profile, including the customer’s investment experience, risk tolerance, liquidity needs, investment objectives, and financial situation and needs.9 The latter requires that the member or associated person perform reasonable diligence to understand the nature of a recommended security or strategy, as well as potential risks, and then determine whether there is a reasonable basis to believe, based on the reasonable diligence, that the recommendation is suitable for at least some investors. The level of reasonable diligence that is required will rise with the complexity and risks associated with the security or strategy. With regard to a complex product such as a volatility-linked ETP, an associated person should be capable of explaining, at a minimum, the product’s main features and associated risks.10

Communications with the Public FINRA Rule 2210 requires, among other things, that all communications with the public be based on principles of fair dealing and good faith, be fair and balanced, and provide a sound basis for evaluating the facts in regard to any particular security or type of security, industry or service.

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October 2017 17-32

Supervision FINRA Rule 3110 requires that member firms establish and maintain a system to supervise the activities of each associated person that is reasonably designed to achieve compliance with applicable securities laws and regulations, and with applicable FINRA rules. A reasonably designed system must be specifically tailored to a member’s business, taking into account, among other things, the nature and complexity of the products offered and the customer base. Firms also must train registered representatives and supervisors about the terms, features and risks of the products they recommend, as well as the factors that would make such products either suitable or unsuitable for certain investors.

Volatility-linked ETPs are complex products that could be easily misunderstood and improperly sold by registered representatives. As discussed in Regulatory Notice 12-03 and noted above, firms should consider whether to use heightened scrutiny and supervision of ETPs.11 Firms must act reasonably to ensure that their registered representatives and supervisors understand the risks presented by such products and that their systems and training are reasonably designed to avoid unsuitable sales or improper communications.12

ConclusionVolatility-linked ETPs are complex products that are not suitable for all investors. Firms are reminded of their obligation to vet complex products, to put reasonable supervisory controls in place, and to train their registered representatives and supervisors to ensure that suitability and other obligations under FINRA rules are met.

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1. Anexchange-tradedproduct(ETP)isasecuritylistedonanexchangethatseekstoprovideexposuretotheperformanceofanindex,benchmark,oractively-managedstrategy.ThemostcommontypeofETPistheexchange-tradedfund(ETF).OtherETPsincludecommoditypools,whichinvestinfutures,andexchange-tradednotes(ETNs),whichtrackanindexorbenchmarkbutaredebtobligationsofanissuerandholdnounderlyingportfolio.Volatility-linkedETPsincludeETPsthatprovideexposuretovolatilityasanasset,asrepresentedbytheVIXorotheranalogousindex.Theseproductstypicallytrackderivativessuchasfuturestoachievevolatilityexposureandhavebeenstructuredascommoditypools,ETFsorETNs.

2. TheVIXiscalculatedusingonemonthputandcalloptionsontheS&P500Indexandisdesignedtomeasurethemarket’sexpectationsofvolatilityinlargecapU.S.stocksoverthenext30-dayperiod.WhiletheVIXisperhapsthebestknownandmostwidelycited,therearenumerousotherindicesthataresimilartotheVIXbutmeasurevolatilityinothermarkets,suchasthemarketsfornon-U.S.stocks,aswellasforinterestrates,currenciesandcommodities.

3. CurrentU.S.-listedvolatilityETPsincludeVIXfuturestrackers,inverseversionsoftheVIXfuturestrackersandtwo-timesleveragedVIXfuturestrackers,aswellasmoresophisticatedstrategiesprovidingexposuretodifferentcombinationsoflongandshortpositionsinVIXfuturesofvaryingmaturities.

4. “Rollyield”ismeasuredbythepercentagedifferencebetweenthepriceofthefuturescontractsoldandthenewonepurchased.Afuturesmarketinwhichtherollyieldisnegative—becausethepricesoffuturescontractsincreaseasthecontractexpirationdatesgofurtheroutintothefuture—issaidtobein“contango.”Conversely,foramarketin“backwardation,”thepricesoffuturescontractsdecreaseasthecontractexpirationdatesgofartheroutintothefuture.Rollingapositioninamarketinbackwardationresultsinapositiverollyield,asthecontractthatissoldhasahigherpricethantheonewithwhichitisreplaced.See FINRA Regulatory Notice 10-51(discussingsalespracticeobligationsforcommodityfutures-linkedsecurities).

5. Forexample,overarecent12-monthperiod,whiletheVIXwasdownaroundsixpercent,onevolatilityETPtrackingtheshort-termVIXfuturesindexlostmorethan70percentofitsvalue.

6. Forexample,accordingtotheacademicresearcherwhodevelopedtheVIX:

“Unlikeothersecuritiestradedonstockexchanges,however,[volatility-linkedETPs]arenotsuitablebuy-and-holdinvestmentsandarevirtuallyguaranteedtolosemoneythroughtime….Thenatureandperformanceof[volatility-linkedETPs]suggestthatasignificantproportionofholdersareeitherirrationaland/orunawareofhowtheseproductsarestructuredandperformthroughtime.Amongthefindingisthat[volatility-linkedETPs]benchmarkedtotheVIXShort-TermFuturesindicesarevirtuallycertaintolosemoneythroughtime....Overtheirthree-yearhistory,theholdersofETPsbench-markedtotheVIXShort-TermFuturesindiceshavelostnearly$4billion.”

Endnotes

RegulatoryNotice 5

October 2017 17-32



See RobertE.Whaley,“TradingVolatility:AtWhatCost?”Journal of Portfolio Management,Fall2013,pp.95-108.See alsoBrendanConway,“No,YourETFDoesn’tTracktheVIXVolatilityIndex–andHerearetheNumbers,”Barron’s(June17,2014);ChrisDieterich,“TheFearGauge:InvestorsShouldAvoidVIXETFs,”Barron’s,(March26,2016).

7. InaFINRAenforcementactionbeingissuedcontemporaneouslywiththis Notice,forexample,FINRAfoundthatcertainbrokersweremakingunsuitablerecommendationsofvolatility-linkedETPstocustomerswiththemistakenbeliefthatsuchproductscouldbeusedasalong-termhedgeontheircustomers’equitypositionsintheeventofamarketdownturn.See Wells Fargo Clearing Services, LLC (AWCNo.2014042465601)(October16,2017).

8. See FINRA Regulatory Notice 12-03(discussingheightenedscrutinyandsupervisionofcomplexproducts).

9. Acustomer’sinvestmentprofilealsoincludesthecustomer’sage,otherinvestments,taxstatus,investmenttimehorizon,andanyotherinformationthecustomermaydisclosetothememberorassociatedpersoninconnectionwithsuchrecommendation.

10. FINRAnotes,aswell,theimportanceofafirm’svettingofnewproducts,particularlynewproductsthatarecomplexorhavepotentiallyhighlevelsofriskassociatedwiththem.See, e.g., FINRARegulatory Notices 05-26(April2005)(highlightingbestpracticesforvettingnewproducts);and09-31(June2009)(remindingfirmsoftheirobligationtovetnewcomplexandnon-traditionalexchange-tradedfunds).

11. See FINRA Regulatory Notice 12-03(discussingheightenedscrutinyandsupervisionofcomplexproducts).

12. Inthisregard,firmsarealsoencouragedtoconsideradoptingeffectiveconflict-reviewpracticesfortheintroductionofcomplexnewproducts,suchasthosehighlightedinFINRA’sOctober2013Report on Conflicts of Interest.

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http://www.barrons.com/articles/no-your-etf-doesnt-track-the-vix-volatility-index-and-here-are-the-numbers-1403010972

http://www.barrons.com/articles/the-fear-gauge-investors-should-avoid-vix-etfs-1458970060



https://www.finra.org/sites/default/files/Industry/p359971.pdf

SummaryThe SEC approved: (1) the adoption of new FINRA Rule 2165 (Financial Exploitation of Specified Adults) to permit members to place temporary holds on disbursements of funds or securities from the accounts of specified customers where there is a reasonable belief of financial exploitation of these customers; and (2) amendments to FINRA Rule 4512 (Customer Account Information) to require members to make reasonable efforts to obtain the name of and contact information for a trusted contact person for a customer’s account.1 New Rule 2165 and the amendments to Rule 4512 become effective February 5, 2018.

The rule text is available in Attachment A.

Questions regarding this Notice should be directed to:

00 James S. Wrona, Vice President and Associate General Counsel, Office of General Counsel (OGC), at (202) 728-8270 or [email protected]; or

00 Jeanette Wingler, Associate General Counsel, OGC, at (202) 728-8013 or [email protected].

Background and DiscussionWith the aging of the U.S. population, financial exploitation of seniors is a serious and growing problem.2 FINRA’s Securities Helpline for Seniors® has highlighted issues relating to financial exploitation of this group of investors, including the need for members to be able to more quickly and effectively address suspected financial exploitation of seniors and other specified adults.3 The amendments to Rule 4512 and new Rule 2165 provide members with a way under FINRA rules to respond to situations in which they have a reasonable basis to believe that financial exploitation has occurred, is occurring, has been attempted or will be attempted. Members can better protect their customers from financial exploitation if they have the ability to contact a customer’s designated trusted contact person and, when appropriate, place a temporary hold on a disbursement of funds or securities from a customer’s account.

1


March 2017

Notice Type00 Rule Amendment and New Rule

Suggested Routing00 Compliance 00 Legal00 Operations00 Registered Representatives00 Senior Management

Key Topics00 Customer Accounts00 Financial Exploitation00 Senior Investors00 Temporary Holds on Disbursements

00 Trusted Contact Persons

Referenced Rules 00 FINRA Rule 201000 FINRA Rule 214000 FINRA Rule 215000 FINRA Rule 216500 FINRA Rule 331000 FINRA Rule 451200 FINRA Rule 1187000 Regulation S-P00 SEA Rule 17a-3

Financial Exploitation of Seniors SEC Approves Rules Relating to Financial Exploitation of Seniors

Effective Date: February 5, 2018

Scope of Amendments and New Rule

Trusted Contact Person—Amendments to Rule 4512

The amendments to Rule 4512 require members to make reasonable efforts to obtain the name of and contact information4 for a trusted contact person5 upon the opening of a non-institutional customer’s account or when updating account information for a non-institutional account in existence prior to the effective date of the amendments (existing account).6 The amendments do not prohibit members from opening and maintaining an account if a customer fails to identify a trusted contact person as long as the member makes reasonable efforts to obtain the information.7 Asking a customer to provide the name and contact information for a trusted contact person ordinarily would constitute reasonable efforts to obtain the information and would satisfy the rule’s requirements.

The amendments also require that, at the time of account opening, a member disclose in writing (which may be electronic) to the customer that the member or an associated person is authorized to contact the trusted contact person and disclose information about the customer’s account to address possible financial exploitation, to confirm the specifics of the customer’s current contact information, health status, or the identity of any legal guardian, executor, trustee or holder of a power of attorney, or as otherwise permitted by Rule 2165.8 In addition, a member is required to provide this disclosure when it attempts to obtain the name of and contact information for a trusted contact person when updating information for currently existing accounts either in the course of the member’s routine and customary business or as otherwise required by applicable laws or rules.9 Members are required to provide this disclosure even if a customer fails to identify a trusted contact.10

The trusted contact person is intended to be a resource for the member in administering the customer’s account, protecting assets and responding to possible financial exploitation. A member may use its discretion in relying on any information provided by the trusted contact person. A member may elect to notify an individual that he or she was named as a trusted contact person; however, the rule does not require such notification.

Members and customers may benefit from the trusted contact information in many different settings. For example, consistent with the disclosure, if a member has been unable to contact a customer after multiple attempts, a member could contact a trusted contact person to inquire about the customer’s current contact information. Or if a customer is known to be ill or infirm and the member has been unable to contact the customer after multiple attempts, the member could contact a trusted contact person to inquire about the customer’s health status. A member also could reach out to a trusted contact person if it suspects that the customer may be suffering from Alzheimer’s disease, dementia or other forms of diminished capacity. A member could contact a trusted contact person to address possible financial exploitation of the customer before placing a temporary hold on a disbursement. In addition, as discussed below, pursuant to Rule

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2165, when information about a trusted contact person is available, a member must notify the trusted contact person orally or in writing, which may be electronic, if the member has placed a temporary hold on a disbursement of funds or securities from a customer’s account, unless the member reasonably believes that the trusted contact person is engaged in the financial exploitation.

Temporary Hold on Disbursement of Funds or Securities—New Rule 2165

Rule 2165 permits, under FINRA rules, a member that reasonably believes that financial exploitation has occurred, is occurring, has been attempted or will be attempted to place a temporary hold on the disbursement of funds or securities from the account of a “specified adult” customer.11 The rule creates no obligation to withhold a disbursement of funds or securities in such circumstances. In this regard, Supplementary Material to Rule 2165 explicitly states that the rule provides members and their associated persons with a safe harbor from FINRA Rules 2010 (Standards of Commercial Honor and Principles of Trade), 2150 (Improper Use of Customers’ Securities or Funds; Prohibition Against Guarantees and Sharing in Accounts) and 11870 (Customer Account Transfer Contracts) when members exercise discretion in placing temporary holds on disbursements of funds or securities from the accounts of specified adults consistent with the requirements of the rule. The Supplementary Material further states that the rule does not require members to place temporary holds on disbursements of funds or securities from the account of a specified adult.12

The definition of “specified adult” in Rule 2165 covers those investors who are particularly susceptible to financial exploitation.13 A “specified adult” is (A) a natural person age 65 and older or (B) a natural person age 18 and older who the member reasonably believes has a mental or physical impairment that renders the individual unable to protect his or her own interests. Supplementary Material to Rule 2165 provides that a member’s reasonable belief that a natural person age 18 and older has a mental or physical impairment that renders the individual unable to protect his or her own interests may be based on the facts and circumstances observed in the member’s business relationship with the person.14 The rule defines the term “account” to include any account of a member for which a specified adult has the authority to transact business.15

The rule has a broad definition of “financial exploitation.” Specifically, financial exploitation would include: (A) the wrongful or unauthorized taking, withholding, appropriation, or use of a specified adult’s funds or securities; or (B) any act or omission taken by a person, including through the use of a power of attorney, guardianship, or any other authority, regarding a specified adult, to: (i) obtain control, through deception, intimidation or undue influence, over the specified adult’s money, assets or property; or (ii) convert the specified adult’s money, assets or property.

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Attachment B

Rule 2165 permits, under FINRA rules, a member to place a temporary hold on a disbursement of funds or securities from the account of a specified adult if the member reasonably believes that financial exploitation of the specified adult has occurred, is occurring, has been attempted or will be attempted.16 A temporary hold pursuant to the rule may be placed on a particular suspicious disbursement(s) but not on other, non-suspicious disbursements.17 Rule 2165 does not apply to transactions in securities. For example, Rule 2165 would not apply to a customer’s order to sell his shares of a stock. However, if a customer requested that the proceeds of a sale of shares of a stock be disbursed out of his account at the member, then the rule could apply to the disbursement of the proceeds where the customer is a “specified adult” and there is reasonable belief of financial exploitation.18

If a member places a temporary hold, Rule 2165 requires that the member immediately initiate an internal review of the facts and circumstances that caused the member to reasonably believe that financial exploitation of the specified adult has occurred, is occurring, has been attempted or will be attempted.19 In addition, the rule requires the member to provide notification of the hold and the reason for the hold to the trusted contact person and all parties authorized to transact business on the account, including, but not limited to, the customer, no later than two business days after the date that the member first placed the hold.20 A member is not required to provide notification to the trusted contact person or a party authorized to transact business on an account, respectively, if the trusted contact person or party is unavailable or the member reasonably believes that the trusted contact person or party has engaged, is engaged, or will engage in the financial exploitation of the specified adult.21 While oral or written (including electronic) notification is permitted under the rule, a member would be required to retain records evidencing the notification.22

Unless a member reasonably believes that doing so would cause further harm to a specified adult, FINRA encourages the member to attempt to resolve a matter with a customer before placing a temporary hold. If a temporary hold is not placed, the rule does not require notifying the trusted contact person. However, once a member places a temporary hold on a disbursement, the rule requires the member to notify the trusted contact person unless the trusted contact person is unavailable or the member reasonably believes that the trusted contact person has engaged, is engaged, or will engage in the financial exploitation of the specified adult. Furthermore, Rule 2165 does not preclude a member from terminating a temporary hold after communicating with either the customer or trusted contact person. A customer’s objection to a temporary hold or information obtained during an exchange with the customer or trusted contact person may be used in determining whether a hold should be placed or lifted. While not dispositive, members should weigh a customer’s or trusted contact person’s objection against other information in determining whether a hold should be placed or lifted.

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While the rule does not require notifying the customer’s registered representative of suspected financial exploitation, a customer’s registered representative may be the first person to detect potential financial exploitation. If the detection occurs in another way, a member may choose to notify and discuss the suspected financial exploitation with the customer’s registered representative, unless the member suspects that the registered representative is involved in the financial exploitation.

The temporary hold authorized by Rule 2165 would expire not later than 15 business days after the date that the member first placed the temporary hold on the disbursement of funds or securities, unless otherwise terminated or extended by an order of a state regulator or agency or court of competent jurisdiction.23 In addition, provided that the member’s internal review of the facts and circumstances supports its reasonable belief that the financial exploitation of the specified adult has occurred, is occurring, has been attempted or will be attempted, the rule permits the member to extend the temporary hold for an additional 10 business days, unless otherwise terminated or extended by an order of a state regulator or agency or court of competent jurisdiction.24

Rule 2165 requires members to retain records related to compliance with the rule, which shall be readily available to FINRA upon request. Retained records required by the rule are records of: (1) requests for disbursement that may constitute financial exploitation of a specified adult and the resulting temporary hold; (2) the finding of a reasonable belief that financial exploitation has occurred, is occurring, has been attempted or will be attempted underlying the decision to place a temporary hold on a disbursement; (3) the name and title of the associated person that authorized the temporary hold on a disbursement; (4) notification(s) to the relevant parties pursuant to the rule; and (5) the internal review of the facts and circumstances supporting the member’s reasonable belief that the financial exploitation of the specified adult has occurred, is occurring, has been attempted or will be attempted.25

In addition, Rule 2165 requires a member that anticipates using a temporary hold to establish and maintain written supervisory procedures reasonably designed to achieve compliance with the rule, including procedures on the identification, escalation and reporting of matters related to financial exploitation of specified adults.26 The rule requires that the member’s written supervisory procedures identify the title of each person authorized to place, terminate or extend a temporary hold on behalf of the member pursuant to the rule and that any such person be an associated person of the member who serves in a supervisory, compliance or legal capacity for the member.27 The rule also requires a member that anticipates placing a temporary hold pursuant to the rule to develop and document training policies or programs reasonably designed to ensure that associated persons comply with the requirements of the rule.28

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1. SeeSecuritiesExchangeActReleaseNo.79964(Feb.3,2017),82FR10059(Feb.9,2017)(NoticeofFilingofPartialAmendmentNo.1andOrderGrantingAcceleratedApprovalofFileNo.SR-FINRA-2016-039)(ApprovalOrder).

2. SeeFINRAInvestorEducationFoundation,FinancialFraudandFraudSusceptibilityintheUnitedStates:ResearchReportfroma2012NationalSurvey(2013)(whichfoundthatU.S.adultsage65andolderaremorelikelytobetargetedforfinancialfraud,includinginvestmentscams,andmorelikelytolosemoneyoncetargeted);TheMetLifeStudyofElderFinancialAbuse:CrimesofOccasion,Desperation,andPredationAgainstAmerica’sElders(June2011)(discussingtheincreasingprevalenceofelderfinancialabuseandnotingthemanyformsofvulnerabilitythat“makeeldersmoresusceptibleto[financial]abuse,”including,amongothers,poorphysicalormentalhealth,lackofmobility,andisolation).See alsoNational Senior Investor Initiative: A Coordinated Series of Examinations, SEC’s Office of Compliance Inspections and Examinations and FINRA(Apr.15,2015)(notingtheincreaseinpersonsaged65andolderlivingintheUnitedStatesandtheconcentrationofwealthinthosepersonsduringatimeofdownwardyieldpressureonconservativeincome-producinginvestments);Protecting Elderly Investors from Financial Exploitation: Questions to Consider(Feb.5,2015)(notingthatoneofthegreatestriskfactorsfordiminishedcapacityisage).

3. SeeFINRA Launches Toll-Free FINRA Securities Helpline for Seniors(Apr.20,2015)andReport on the FINRA Securities Helpline for Seniors(Dec.2015).

4. Whiletheamendmentsdonotspecifywhatcontactinformationshouldbeobtained,FINRAbelievesthatamailingaddress,phonenumberandemailaddressforthetrustedcontactpersonmaybethemostusefultomembers.

5. Thetrustedcontactpersonmustbeage18orolder. SeeRule4512(a)(1)(F).

6. ConsistentwiththecurrentrequirementsofRule4512,amemberwouldnotneedtoattempttoobtainthenameofandcontactinformationforatrustedcontactpersonforaccountsinexistencepriortotheeffectivedateoftheamendments(existingaccounts)untilsuchtimeasthememberupdatestheinformationfortheaccounteitherinthecourseofthemember’sroutineandcustomarybusinessorasotherwiserequiredbyapplicablelawsorrules.SeeRule4512(b).WithrespecttoanyaccountsubjecttotherequirementsofSecuritiesExchangeAct(SEA)Rule17a-3(a)(17)toperiodicallyupdatecustomerrecords,amemberisrequiredtomakereasonableeffortstoobtainor,ifpreviouslyobtained,toupdatewhereappropriatethenameofandcontactinformationforatrustedcontactpersonconsistentwiththerequirementsinSEARule17a-3(a)(17).SeeSupplementaryMaterial.06(c)toRule4512.See alsoSEARule17a-3(a)(17)(i)(A)and(i)(D).

WithregardtoupdatingthecontactinformationonceprovidedforotheraccountsthatarenotsubjecttotherequirementsinSEARule17a-3,amembershouldconsideraskingthecustomertoreviewandupdatethenameofandcontactinformationforatrustedcontactpersononaperiodicbasisorwhenthereisareasontobelievethattherehasbeenachangeinthecustomer’ssituation.

Endnotes

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Membersshouldnoteaswellthatacustomer’srequesttochangehisorhertrustedcontactpersonmaybeapossibleredflagoffinancialexploitation.Forexample,aseniorcustomerinstructinghisregisteredrepresentativetochangehistrustedcontactpersonfromanimmediatefamilymembertoapreviouslyunknownthirdpartymaybearedflagoffinancialexploitation.

7. SeeSupplementaryMaterial.06(b)toRule4512.

8. AstheSEC’sApprovalOrderconfirms,members’disclosurestotrustedcontactpersonspursuanttoRules4512(a)(1)(F)and2165wouldbeconsistentwithRegulationS-Pbecausesuchdisclosureswouldbemadewithcustomers’consentorauthorization,toprotectagainstfraudorunauthorizedtransactions,ortocomplywithfederal,state,orlocallaws,rulesandotherapplicablelegalrequirements.SeeApprovalOrder,supranote1,at10068andn.159.

9. SeeSupplementaryMaterial.06(a)toRule4512.

10. Amongotherthings,suchdisclosuremayassistacustomerinmakinganinformeddecisionaboutwhethertoprovidethetrustedcontactpersoninformation.

11. SeeRule2165(b)(1).MembersalsomustconsideranyobligationsunderFINRARule3310(Anti-MoneyLaunderingComplianceProgram)andthereportingofsuspicioustransactionsrequiredunder31U.S.C.5318(g)andtheimplementingregulationsthereunder.

Inaddition,duringtherulemakingprocesssomecommentersaskedwhetherRule2165compliedwiththerequirementsofSection22(e)oftheInvestmentCompanyActof1940.FINRAnotedthatmostmutualfundcustomeraccountsareservicedandrecord-keptbyintermediaries.Inthesmallproportionofcircumstanceswhere

mutualfundcustomerspurchasesharesdirectlyfromthemutualfund,thecustomer’saccountmaybemaintainedbyamutualfund’sprincipalunderwriter.TheSEC’sApprovalOrderconfirmsthat,ingeneral,abroker-dealer’sdelayofadisbursementofmutualfundredemptionproceedstoitscustomersinrelianceonRule2165andbasedonareasonablebeliefoffinancialexploitationofthecustomerwouldnotbeimputedtothemutualfund,includingwherethebroker-dealeristhefund’sprincipalunderwriter.See ApprovalOrder,supranote1,at10066.However,thisconclusionislimitedtosituationswherethemutualfunddoesnothavearoleinthedisbursementofredemptionproceedsfromthecustomer’saccountheldbythebroker-dealer,includinganyroleinthedecisiontodelaythedisbursementoffundsinrelianceonRule2165. Id.

12. SeeSupplementaryMaterial.01toRule2165.

13. Seesupranote2.

14. SeeSupplementaryMaterial.03toRule2165.FINRAnotesthatamembermaynotignorecontraryevidenceinmakingadeterminationbasedonthefactsandcircumstancesobservedinthemember’sbusinessrelationshipwiththenaturalperson(e.g.,acourtorder).

15. Morethanonefinancialinstitutionmaybeprovidingservicesinsomearrangementsandbusinessmodels.Insucharrangements,thefinancialinstitutionthathasareasonablebeliefthatfinancialexploitationisoccurringmaynotholdtheassetsthataresubjecttothedisbursementrequest.Forexample,withrespecttointroducingandclearingfirmarrangements,anintroducingfirmmaymakethedeterminationthatplacingatemporaryholdpursuanttotheproposedrulechangeisappropriate.Theclearingfirmmaythenplacethetemporaryholdat

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thedirectionofandinreasonablerelianceontheinformationprovidedbytheintroducingfirm.FINRArecognizesthatmembersmakingadeterminationorrecommendationtoplaceaholdonadisbursementmaynotbeinthepositiontoplacetheactualholdonthefundsorsecurities.

16. SeeRule2165(b)(1)(A).

17. FINRArecognizesthatasingledisbursementcouldinvolvealloftheassetsinanaccount.ForpurposesofRule2165,moreover,FINRAwouldconsiderdisbursementstoincludeACATStransfersbut,aswithanytemporaryhold,amemberwouldneedtohaveareasonablebeliefoffinancialexploitationinordertoplaceatemporaryholdontheprocessingofanACATStransferrequestpursuanttotherule.FINRAremindsmembersoftheapplicationofFINRARule2140(InterferingWiththeTransferofCustomerAccountsintheContextofEmploymentDisputes)totheextentthatthereisnotareasonablebeliefoffinancialexploitation.Furthermore,inthecaseofatemporaryholdonanACATStransferrequest,themembermustpermitdisbursementsfromtheaccountwherethereisnotareasonablebeliefoffinancialexploitationregardingsuchdisbursements(e.g., acustomer’sregularbillpayments).FINRAalsore-emphasizesthatwhereaquestionabledisbursementinvolveslessthanallassetsinanaccount,amembermaynotplaceablanketholdontheentireaccount.Eachdisbursementmustbeanalyzedseparately.Inaddition,takingintoaccountamember’ssizeandbusiness,FINRAwouldcloselyexamineamemberthatplacesanoutsizednumberofholdsoncustomeraccountstodeterminewhethertherewasanywrongdoingonthepartofthemember.

18. WhileRule2165doesnotapplytotransactions,FINRAmayconsiderextendingthesafeharbortotransactionsinsecuritiesinfuturerulemaking.

19. SeeRule2165(b)(1)(C).

20. SeeRule2165(b)(1)(B).FINRAunderstandsthatamembermaynotnecessarilybeabletospeakwithorotherwisegetaresponsefromsuchpersonswithinthetwo-business-dayperiod.FINRAwouldconsider,forexample,amember’smailingaletter,sendinganemail,orplacingatelephonecallandleavingamessagewithappropriateperson(s)withinthetwo-business-dayperiodtoconstitutenotificationforpurposesofRule2165.

21. FINRAwouldconsiderthelackofanidentifiedtrustedcontactperson,theinabilitytocontactthetrustedcontactperson,oraperson’srefusaltoactasatrustedcontactpersontomeanthatthetrustedcontactpersonwasnotavailable.Furthermore,FINRAwouldconsidertheinabilitytocontactapartyauthorizedtotransactbusinessonanaccounttomeanthatthepartywasnotavailable.

22. SeeRule2165(d).

23. SeeRule2165(b)(2).

24. SeeRule2165(b)(3).

25. SeeRule2165(d).

26. SeeRule2165(c)(1).

27. SeeRule2165(c)(2).Thisprovisionisintendedtoensurethatamember’sdecisiontoplaceatemporaryholdiselevatedtoanassociatedpersonwithappropriateauthority.

28. SeeSupplementaryMaterial.02toRule2165.

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Attachment A

New and Amended Rule TextNewlanguageisunderlined;deletionsareinbrackets.

* * * * *

Text of New FINRA Rule

* * * * *

2100. TRANSACTIONS WITH CUSTOMERS

* * * * *

2165. Financial Exploitation of Specified Adults

(a) Definitions

(1) For purposes of this Rule, the term “Specified Adult” shall mean: (A) a natural person age 65 and older; or (B) a natural person age 18 and older who the member reasonably believes has a mental or physical impairment that renders the individual unable to protect his or her own interests.

(2) For purposes of this Rule, the term “Account” shall mean any account of a member for which a Specified Adult has the authority to transact business.

(3) For purposes of this Rule, the term “Trusted Contact Person” shall mean the person who may be contacted about the Specified Adult’s Account in accordance with Rule 4512.

(4) For purposes of this Rule, the term “financial exploitation” means:

(A) the wrongful or unauthorized taking, withholding, appropriation, or use of a Specified Adult’s funds or securities; or

(B) any act or omission by a person, including through the use of a power of attorney, guardianship, or any other authority regarding a Specified Adult, to:

(i) obtain control, through deception, intimidation or undue influence, over the Specified Adult’s money, assets or property; or

(ii) convert the Specified Adult’s money, assets or property.

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(b) Temporary Hold on Disbursements

(1) A member may place a temporary hold on a disbursement of funds or securities from the Account of a Specified Adult if:

(A) The member reasonably believes that financial exploitation of the Specified Adult has occurred, is occurring, has been attempted, or will be attempted; and

(B) The member, not later than two business days after the date that the member first placed the temporary hold on the disbursement of funds or securities, provides notification orally or in writing, which may be electronic, of the temporary hold and the reason for the temporary hold to:

(i) all parties authorized to transact business on the Account, unless a party is unavailable or the member reasonably believes that the party has engaged, is engaged, or will engage in the financial exploitation of the Specified Adult; and

(ii) the Trusted Contact Person(s), unless the Trusted Contact Person is unavailable or the member reasonably believes that the Trusted Contact Person(s) has engaged, is engaged, or will engage in the financial exploitation of the Specified Adult; and

(C) The member immediately initiates an internal review of the facts and circumstances that caused the member to reasonably believe that the financial exploitation of the Specified Adult has occurred, is occurring, has been attempted, or will be attempted.

(2) The temporary hold authorized by this Rule will expire not later than 15 business days after the date that the member first placed the temporary hold on the disbursement of funds or securities, unless otherwise terminated or extended by a state regulator or agency of competent jurisdiction or a court of competent jurisdiction, or extended pursuant to paragraph (b)(3) of this Rule.

(3) Provided that the member’s internal review of the facts and circumstances under paragraph (b)(1)(C) of this Rule supports the member’s reasonable belief that the financial exploitation of the Specified Adult has occurred, is occurring, has been attempted, or will be attempted, the temporary hold authorized by this Rule may be extended by the member for no longer than 10 business days following the date authorized by paragraph (b)(2) of this Rule, unless otherwise terminated or extended by a state regulator or agency of competent jurisdiction or a court of competent jurisdiction.

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(c) Supervision

(1) In addition to the general supervisory and recordkeeping requirements of Rules 3110, 3120, 3130, 3150, and Rule 4510 Series, a member relying on this Rule shall establish and maintain written supervisory procedures reasonably designed to achieve compliance with this Rule, including, but not limited to, procedures related to the identification, escalation and reporting of matters related to the financial exploitation of Specified Adults.

(2) A member’s written supervisory procedures also shall identify the title of each person authorized to place, terminate or extend a temporary hold on behalf of the member pursuant to this Rule. Any such person shall be an associated person of the member who serves in a supervisory, compliance or legal capacity for the member.

(d) Record Retention

Members shall retain records related to compliance with this Rule, which shall be readily available to FINRA, upon request. The retained records shall include records of: (1) request(s) for disbursement that may constitute financial exploitation of a Specified Adult and the resulting temporary hold; (2) the finding of a reasonable belief that financial exploitation has occurred, is occurring, has been attempted, or will be attempted underlying the decision to place a temporary hold on a disbursement; (3) the name and title of the associated person that authorized the temporary hold on a disbursement; (4) notification(s) to the relevant parties pursuant to paragraph (b)(1)(B) of this Rule; and (5) the internal review of the facts and circumstances pursuant to paragraph (b)(1)(C) of this Rule.

• • • Supplementary Material: --------------

.01 Applicability of Rule. This Rule provides members and their associated persons with a safe harbor from FINRA Rules 2010, 2150 and 11870 when members exercise discretion in placing temporary holds on disbursements of funds or securities from the Accounts of Specified Adults consistent with the requirements of this Rule. This Rule does not require members to place temporary holds on disbursements of funds or securities from the Accounts of Specified Adults.

.02 Training. A member relying on this Rule must develop and document training policies or programs reasonably designed to ensure that associated persons comply with the requirements of this Rule.

.03 Reasonable Belief of Mental or Physical Impairment. A member’s reasonable belief that a natural person age 18 and older has a mental or physical impairment that renders the individual unable to protect his or her own interests may be based on the facts and circumstances observed in the member’s business relationship with the natural person.

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* * * * *

Amendment to FINRA Rule

* * * * *

4500. BOOKS, RECORDS AND REPORTS

* * * * *

4512. Customer Account Information

(a) Each member shall maintain the following information:

(1) for each account:

(A) through (C) No Change.

(D) signature of the partner, officer or manager denoting that the account has been accepted in accordance with the member’s policies and procedures for acceptance of accounts; [and]

(E) if the customer is a corporation, partnership or other legal entity, the names of any persons authorized to transact business on behalf of the entity; and

(F) subject to Supplementary Material .06, name of and contact information for a trusted contact person age 18 or older who may be contacted about the customer’s account; provided, however, that this requirement shall not apply to an institutional account.

(2) through (3) No Change.

(b) through (c) No Change.

• • • Supplementary Material: --------------

.01 through .05 No Change.

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.06 Trusted Contact Person

(a) With respect to paragraph (a)(1)(F) of this Rule, at the time of account opening a member shall disclose in writing, which may be electronic, to the customer that the member or an associated person of the member is authorized to contact the trusted contact person and disclose information about the customer’s account to address possible financial exploitation, to confirm the specifics of the customer’s current contact information, health status, or the identity of any legal guardian, executor, trustee or holder of a power of attorney, or as otherwise permitted by Rule 2165. With respect to any account that was opened pursuant to a prior FINRA rule, a member shall provide this disclosure in writing, which may be electronic, when updating the information for the account pursuant to paragraph (b) of this Rule either in the course of the member’s routine and customary business or as otherwise required by applicable laws or rules.

(b) The absence of the name of or contact information for a trusted contact person shall not prevent a member from opening or maintaining an account for a customer, provided that the member makes reasonable efforts to obtain the name of and contact information for a trusted contact person.

(c) With respect to any account subject to the requirements of SEA Rule 17a-3(a)(17) to periodically update customer records, a member shall make reasonable efforts to obtain or, if previously obtained, to update where appropriate the name of and contact information for a trusted contact person consistent with the requirements of SEA Rule 17a-3(a)(17).

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common examination findings and compliance …...common examination findings and compliance...

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