Reforms To FINRAs Examination Program are Focused on Fraud Detection What Does this Mean for Those Who are the Subject ofa FINRA Inquiry

By Sylvia Scott bull

Since the financial crisis the Madoff and Stanford cases and other high profile scandals the Financial Industry Regulatory Authority (FINRA) the Securities and Exchange Commission (SEC) and other regulators have been under tremendous pressure to adopt reforms to increase their effectiveness in identifying securities fraud In testimony before the Subcommittee on Oversight and Investigations on Financial Services the Chairman and CEO of FINRA Richard Ketchum testified

Unfortunately we are here today because of a massive fraud that has had tragic results for many investors No regulator can feel good about its performance regarding Stanford Notwithstanding the jurisdictional limits that confronted us FINRA clearly could have done better and we deeply regret we did not In the wake of Stanford FINRA stepped back and took

a hard look at our regulatory programs and approaches and searched for ways to more effectively uncover misconduct especially fraud and enhance our programs to better protect investors

Testimony Before the Subcommittee on Oversight and Investigations on Financial Services U S House ofRepresentatives May 13 2011 wwwfinraorgNewsrooml Speeche~etchumAD123672

FINRA responded to these unfortunate events by establishing a Special Review Committee in 2009 to conduct an audit of its examination program as it related to the prevention and detection of fraud In September 2009 the Special Review Committee issued a report recommending that FINRA reform its examination program to ensure that fraud detection is given top priority

The Special Committee recommends that FINRAs examination program should be revamped to ensure that fraud detection and prevention are core elements This is particularly critical when the potential fraud poses risk of significant harm to investors Allegations of the magnitude and gravity of those in the Stanford case should be given the highest priority immediately escalated to FINRA senior management and vigorously pursued by well-trained FINRA staff with all necessary investigative tools and techniques

bull Sylvia Scott is a partner at the Los Angeles-based law firm of Freeman Freeman amp Smiley LLP and a former enforcement attomey with FINRA and the SEC

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See Report of the 2009 Special Review Committee on FINRAs Examination Program in Light of the Stanford and Madoff Schemes (Special Review Committee Report) wwwfinraorgwebgroupscorporatecorpdocumentscorporatep120078pdf

The Special Review Committee recommended a number of specific reforms all of which FINRA has adopted or is in the process of adopting including the creation of a dedicated fraud detection unit and the enhancement of technological tools for analyzing data and documents The following discussion will address (1) FINRA examination basics and the evolving regulatory landscape (2) specific reforms to FINRAs examination program and (3) what to do when faced with a FINRA examination or inquiry

FINRA Examination Basics and the Evolving Regulatory Landscape

FINRA operates under authority granted to it by the 1938 Maloney Act Amendments to the Securities Exchange Act of 1934 FINRA is the largest selfshyregulatory organization for the securities industry in the world with approximately 3000 employees variously operating out of Washington DC New York City and 20 regional offices FINRA was formed in 2007 by a consolidation of the NASD and the enforcement arm of the New York Stock Exchange (NYSE Regulation Inc)

Virtually all broker-dealers in the United States that conduct a securities business with the public are required to register with FINRA FINRA is responsible for regulating

the activities of approximately 4600 broker-dealer member firms and approximately 631000 registered securities representatives FINRAs primary duties include enforcement of all rules and regulations applicable to its members and their associated persons The SEC regulates and oversees the activities of FINRA and must approve all FINRA rules

The scope of FINRAs jurisdiction extends only to broker-dealer members and their associated persons FINRA retains jurisdiction over former associated persons for up to two years after they have left the industry However this two-year period can begin anew if an amendment to the brokers notice of termination is filed within that period disclosing certain reportable conduct With regard to persons outside of its jurisdiction FINRA may make a referral to the SEC or a state regulator depending upon the facts and circumstances of a given case There have been recommendations to broaden the scope of FINRAs jurisdiction to include registered investment advisers (including recommendations by the Special Review Committee) but these recommendations have yet to become a reality The debate on this issue continues

There are two types of FINRA examinations routine examinations and cause examinations Routine examinations also referred to as cycle examinations are conducted on a cyclical basis using a risk-based approach Firms are identified and prioritized for examination based on a quantitative and qualitative risk-assessment process that takes into account among other things the size of the firm certain financial condition risks the regulatory history of individuals registered with the firm and customer complaints about the firm or its registered individuals In light of FINRAs riskshy

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based approach to routine examinations firms that are the subject of such examinations should not treat them as routine despite their label

Each year FINRA publishes on its website (wwwfinraorg) its Annual Regulatory and Examination Priorities Letter to highlight new and existing areas of significance to FINRAs examination program The examination priorities outlined in this letter represent FINRAs current assessment of key risk factors facing the industry The 2011 Examination Priorities Letter outlines 20 examination priorities Fraud is at the very top of the list FINRAs examination priorities have been and continue to be significantly influenced by the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) as new rules and regulations are adopted pursuant to various DoddshyFrank provisions and initiatives

Cause examinations are more narrowly focused examinations and are based on investor complaints referrals generated by FINRAs market surveillance systems terminations of individual brokers for cause arbitrations and referrals from other regulators In March 2009 FINRA created its Office of the Whistleblower to expedite the review of high-risk tips by FINRA senior staff and ensure a rapid response for tips believed to have merit Daniel M Sibears Executive Vice President Member Regulation Programs Before the Committee on Banking Housing and Urban Affairs United States Senate (August 17 2009) wwwfinraorglNewsroomISpeecheslSibearsl P119812 FINRAs Office of the Whistleblower generates whistleblower tips for the cause examination program FINRA also conducts special sweep examinations with respect to issues of particular concern that are identified often in consultation with the SEC and state regulators

At the conclusion of a routine or cause examination FINRA staff typically prepare a report addressing apparent rule violations that are considered for possible disciplinary action If the examination staff working together with enforcement staff determines that disciplinary action is warranted potential respondents are typically notified of this preliminary determination and given the opportunity to make a written submission to the staff arguing why enforcement action is not warranted This submission for historical reasons is referred to as a Wells Submission

If the staff is unconvinced by the Wells Submission it will seek authority from the Office of Disciplinary Affairs to initiate a formal enforcement action If a formal enforcement action is filed the staff will seek sanctions including fines suspensions from the securities business andor expUlsion from the industry FINRA may also require restitution to investors and make a referral to the criminal authorities in the most egregious cases In 2010 FINRA staff was very busy They brought 1310 disciplinary actions conducted approximately 2600 routine examinations and conducted approximately 7300 cause examinations

Recent Reforms to FINRAs Examination Program to Detect and Prevent Fraud

Following the recommendations of the Special Review Committee in October 2009 FINRA created the Office of Fraud Detection and Market Intelligence (OFDMI)

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The OFDMI comprises the Central Review Group Office of the Whistleblower and the Insider Trading and Fraud Surveillance teams These teams are collectively responsible for the centralized intake and evaluation of regulatory filings and investor complaints The purpose of the OFDMI is to enable an expedited response to potentially serious frauds and the escalation of such matters to senior level reviews to avoid another Madoff or Stanford scandal According to FINRA statistics in 2010 the OFDMI referred more than 550 matters involving potentially fraudulent conduct to the SEC or other regulators for further investigation

FINRA implemented additional reforms by enhancing its examination program to include the following policies and procedures

1 Allocation of Regulatory Resources to High-Priority Matters Emphasized throughout the Special Review Committee Report was the allocation of regulatory resources to urgent matters To address this concern FINRA has created an urgent designation for matters posing the greatest potential for Significant risk to investors Matter that are designated as urgent receive expedited treatment and are given special attention by examiners and senior management In response to a finding by the Special Review Committee that FINRA lacked a formal mechanism for the escalation of policy issues FINRA has adopted a new policy to enhance the process for escalating and documenting complex legal and policy issues

2 Increasing and Leveraging the Expertise of FINRA Staff FINRA has added staff to the district offices to conduct surveillance operations that target specific firms This surveillance includes real-time monitoring of business and financial changes occurring at a firm These reforms are designed to enhance an examiners ability to evaluate regulatory information and to conduct more focused examinations based on that information FINRA has also redesigned an existing program to identify staff with special expertise in specific subject matters to assist in staff training risk assessment and case evaluations Staff training in the area of securities fraud detection was also enhanced

3 Enhanced Use of External Information FINRA is working with third parties to identify available data sources that may be incorporated into its examination programs FINRA now requires firms that are designated high risk to submit financial data on a more frequent basis FINRA has also instituted a process to review all employershyemployee related statements of claim filed with FINRA Dispute Resolution in addition to customer-related statements of claim that FINRA had previously reviewed and continues to review FINRA further expanded the arbitration review process to include review of all amended claims counter claims cross claims and third-party claims

4 Technology Enhancement Plan FINRA has adopted a number of technology-based enhancements including an enterprise search tool which allows its staff to access internal regulatory intelligence by conducting searches for information and documents across FINRAs regulatory areas FINRA is also overhauling existing applications and tools used to conduct examinations and reviews by its regulatory staff

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5 Enhanced Coordination with the SEC FINRA has increased the level of its communication and coordination with the SEC FINRA and SEC staff meet routinely to share information and discuss risk assessment including standards to measure risk of broker-dealers branch offices and registered representatives

6 Risk-Based Examinations In late 2010 FINRA created the Office of Risk to strengthen its ability to identify high-risk firms branch offices brokers activities and products through broader information gathering and more comprehensive analyses FINRA uses this information to better assess the risks that exist for individual firms and to tailor regulatory responses to those risks

How Should One Respond to a FINRA Examination or Inquiry

The short answer is timely completely and thoughtfully The failure to take regulatory examinations or inquiries seriously can have severe consequences particularly in the current regulatory environment Additionally FINRA Rule 8210 requires its members and persons associated with a member firm to provide information orally [or] in writing with respect to any matter involved in [a FINRA] examination Rule 8210 also states that FINRA has the right to inspect and copy the books records and accounts of such member or person with respect to any matter involved in [a FINRA] examination Failure to comply with Rule 8210 can result in severe sanctions including an expulsion or bar from the industry FINRAs jurisdiction generally encompasses any securities related activities by a FINRA member firm or its associated person that is governed by FINRAs rules the Securities Exchange Act of 1934 and the Municipal Securities Rulemaking Board (MSRB) rules

However firms and individuals are not required to turn over information that is protected by the attorney-client privilege Care should be taken not to inadvertently turn over such privileged information as may occur when responding to requests for electronic communications Because the application of the attorney-client privilege can be confusing at times careful research and analyses should be conducted to avoid running afoul ofRule 8210 in the event documents are improperly withheld

With regard to routine examinations a firm will usually receive a document request list either prior to or at the time of the on-site examination As the examiners review the documents during the examination they are likely to have questions that they may ask orally or in writing Examiners will frequently send seemingly informal emails posing various questions of the firm The most important thing a firm can do in anticipation of such an examination is to have a strong compliance program that is tailored to its business model Firms must periodically evaluate their compliance programs and conduct their own risk assessments to identify problems before FINRA arrives

In handling a routine examination firms should adopt the following best practices

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1 Be courteous to the examiner and provide him or her with a comfortable workspace

2 Be aware of the latest regulatory rules and initiatives as these will inevitably be examination priorities

3 Review past deficiency letters issued by FINRA

4 Make sure the firms files are well organized and complete

5 Review the documents routine exam request list ask the examiner for clarification if necessary and flag possible areas of concern for follow-up

6 Designate a contact at your firm to interface with the examiner This person should be knowledgeable of the firms compliance program and business model

7 Maintain a log of documents requested and produced

8 Address and correct any apparent miscommunications

9 If there are any contested issues address them before the fieldwork portion of the cycle exam is concluded

10 Never provide false or misleading information to a regulator

In the event of a cause examination (for example a customer complaint or whistleblower tip) the examiner usually sends a request letter to the recipient asking a number of questions and requiring the production of documents If the examiner believes that the matter involves potentially serious violations and more detailed questioning is required then the staff will schedule on-the-record (OTR) testimony This is a formal interview process with a court reporter and the introduction of exhibits about which the witness will be questioned Persons required to participate in OTRs may have counsel pre~ent FINRA may also conduct informal interviews of investors Oftentimes investor declarations are obtained

During the cause examination process many of the same principles that apply to routine examinations apply here In addition persons that are the subject of cause examination should get ahead of the curve by conducting their own investigation and analysis of the issues under examination by FINRA While the facts should speak for themselves it is critical that the subject of an investigation take proactive steps to educate the staff and potentially ward off a devastating chain of events

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5 Enhanced Coordination with the SEC FINRA has increased the level of its communication and coordination with the SEC FINRA and SEC staff meet routinely to share information and discuss risk assessment including standards to measure risk of broker-dealers branch offices and registered representatives

6 Risk-Based Examinations In late 2010 FINRA created the Office of Risk to strengthen its ability to identify high-risk firms branch offices brokers activities and products through broader information gathering and more comprehensive analyses FINRA uses this information to better assess the risks that exist for individual firms and to tailor regulatory responses to those risks

How Should One Respond to a FINRA Examination or Inquiry

The short answer is timely completely and thoughtfully The failure to take regulatory examinations or inquiries seriously can have severe consequences particularly in the current regulatory environment Additionally FINRA Rule 8210 requires its members and persons associated with a member firm to provide information orally [or] in writing with respect to any matter involved in [a FINRA] examination Rule 8210 also states that FINRA has the right to inspect and copy the books records and accounts of such member or person with respect to any matter involved in [a FINRA] examination Failure to comply with Rule 8210 can result in severe sanctions including an expulsion or bar from the industry FINRAs jurisdiction generally encompasses any securities related activities by a FINRA member firm or its associated person that is governed by FINRAs rules the Securities Exchange Act of 1934 and the Municipal Securities Rulemaking Board (MSRB) rules

However firms and individuals are not required to turn over information that is protected by the attorney-client privilege Care should be taken not to inadvertently turn over such privileged information as may occur when responding to requests for electronic communications Because the application of the attorney-client privilege can be confusing at times careful research and analyses should be conducted to avoid running afoul ofRule 8210 in the event documents are improperly withheld

With regard to routine examinations a firm will usually receive a document request list either prior to or at the time of the on-site examination As the examiners review the documents during the examination they are likely to have questions that they may ask orally or in writing Examiners will frequently send seemingly informal emails posing various questions of the firm The most important thing a firm can do in anticipation of such an examination is to have a strong compliance program that is tailored to its business model Firms must periodically evaluate their compliance programs and conduct their own risk assessments to identify problems before FINRA arrives

In handling a routine examination firms should adopt the following best practices

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1 Be courteous to the examiner and provide him or her with a comfortable workspace

2 Be aware of the latest regulatory rules and initiatives as these will inevitably be examination priorities

3 Review past deficiency letters issued by FINRA

4 Make sure the firms files are well organized and complete

5 Review the documents routine exam request list ask the examiner for clarification if necessary and flag possible areas of concern for follow-up

6 Designate a contact at your firm to interface with the examiner This person should be knowledgeable of the firms compliance program and business model

7 Maintain a log of documents requested and produced

8 Address and correct any apparent miscommunications

9 If there are any contested issues address them before the fieldwork portion of the cycle exam is concluded

10 Never provide false or misleading information to a regulator

In the event of a cause examination (for example a customer complaint or whistleblower tip) the examiner usually sends a request letter to the recipient asking a number of questions and requiring the production of documents If the examiner believes that the matter involves potentially serious violations and more detailed questioning is required then the staff will schedule on-the-record (OTR) testimony This is a formal interview process with a court reporter and the introduction of exhibits about which the witness will be questioned Persons required to participate in OTRs may have counsel pre~ent FINRA may also conduct informal interviews of investors Oftentimes investor declarations are obtained

During the cause examination process many of the same principles that apply to routine examinations apply here In addition persons that are the subject of cause examination should get ahead of the curve by conducting their own investigation and analysis of the issues under examination by FINRA While the facts should speak for themselves it is critical that the subject of an investigation take proactive steps to educate the staff and potentially ward off a devastating chain of events

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1 Be courteous to the examiner and provide him or her with a comfortable workspace

2 Be aware of the latest regulatory rules and initiatives as these will inevitably be examination priorities

3 Review past deficiency letters issued by FINRA

4 Make sure the firms files are well organized and complete

5 Review the documents routine exam request list ask the examiner for clarification if necessary and flag possible areas of concern for follow-up

6 Designate a contact at your firm to interface with the examiner This person should be knowledgeable of the firms compliance program and business model

7 Maintain a log of documents requested and produced

8 Address and correct any apparent miscommunications

9 If there are any contested issues address them before the fieldwork portion of the cycle exam is concluded

10 Never provide false or misleading information to a regulator

In the event of a cause examination (for example a customer complaint or whistleblower tip) the examiner usually sends a request letter to the recipient asking a number of questions and requiring the production of documents If the examiner believes that the matter involves potentially serious violations and more detailed questioning is required then the staff will schedule on-the-record (OTR) testimony This is a formal interview process with a court reporter and the introduction of exhibits about which the witness will be questioned Persons required to participate in OTRs may have counsel pre~ent FINRA may also conduct informal interviews of investors Oftentimes investor declarations are obtained

During the cause examination process many of the same principles that apply to routine examinations apply here In addition persons that are the subject of cause examination should get ahead of the curve by conducting their own investigation and analysis of the issues under examination by FINRA While the facts should speak for themselves it is critical that the subject of an investigation take proactive steps to educate the staff and potentially ward off a devastating chain of events

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