On February 9, 2022, FINRA released the FINRA Risk Monitoring and Examination Activities Report. The report provides guidance on FINRA’s current examination priorities and describes its examination findings during the past year. It covers 21 different topics including 5 new subjects in which MCG operates with the utmost proficiency:
· Firm Short Positions and Fails-to-Receive in Municipal Securities;
· Trusted Contact Persons;
· Funding Portals and Crowdfunding Offerings;
· Disclosure of Routing Information; and
· Portfolio Margin and Intraday Trading.
The securities industry is highly dynamic in terms of business models, technologies, products and compliance practices. Allow MCG Consulting, LLC to help you navigate the complexities of this evolving financial landscape. MCG encourages FINRA member firms to review FINRA’s “Examination and Risk Monitoring Program” report in its entirety, especially the areas relevant to their businesses. Our team of experienced compliance professionals can help your firm develop and maintain a high-quality compliance program customized to your unique regulatory requirements, business demands, and operational challenges.
Click below for further information regarding the FINRA Risk Monitoring and Examination Activities Report.
Firm Short Positions and Fails-to-Receive in Municipal Securities
As detailed in Regulatory Notice 15-27, customers may receive taxable, substitute interest instead of the tax-exempt interest they were expecting when a firm effects sales to customers of municipal securities that are not under the firm’s possession or control.7 This can occur when firm trading activity inadvertently results in a short position or a firm fails to receive municipal securities it purchases to fulfill a customer’s order.
Firms must develop and implement adequate controls and procedures for detecting, resolving and preventing these adverse tax consequences to customers. Such procedures must include closing out fails-to-receive within the time frame prescribed within Municipal Securities Rule-making Board (MSRB) Rule G-12(h) and confirming that their communications with customers regarding the tax status of paid or accrued interest for municipal securities are neither false nor misleading, in accordance with MSRB Rule G-17.
· Does your firm use exception reports to manage its municipal securities’ short positions or fails-to-receive? If so, how does your firm use such reports, and which departments are responsible for managing them?
· When municipal securities short positions are identified, does your firm begin to cover the shorts, or do they wait until the trades have settled?
· What is your firm’s process to close out fails-to-receive in accordance with the methods and time frame prescribed under MSRB G-12(h)?
· How does your firm detect instances that would require them to pay customers substitute interest? In those circumstances, what is the firm’s process for notifying impacted customers and paying them substitute interest in a timely manner? If a customer does not want to receive substitute interest, what alternatives does the firm offer (e.g., offering to cancel the transaction and purchasing a comparable security that would provide tax-exempt interest)?
· How does your firm handle inbound or outbound account transfers sent through the Automated Customer Account Transfer Service (ACAT) that are delivered with no corresponding municipal bonds in possession or control?
· Inadequate Controls and Procedures – Not maintaining adequate procedures and controls for preventing, identifying and resolving adverse consequences to customers when a firm does not maintain possession or control of municipal securities that a customer owns.
· Inadequate Lottery Systems – Opting to use a random lottery system to allocate municipal short positions to certain customer accounts, but the system did not fairly or adequately account for or allocate substitute accrued interest payments.
· Preventative Controls – Maintaining processes to prevent or timely remediate municipal positions from settling short (e.g., covering these positions, finding a suitable alternative, cancelling the customer’s purchase).
· Operational and Supervisory Reports – Developing operational and supervisory reports to identify customer long positions for which the firm has not taken possession and control of the security.
· Review of Fail Reports – Municipal securities principals performing regular, periodic reviews of Fail Reports to comply with the close-out requirements of MSRB Rule G12-(h).
Trusted Contact Persons
FINRA Rule 4512(a)(1)(F) (Customer Account Information) requires firms, for each of their non-institutional customer accounts, to make a reasonable effort to obtain the name and contact information for a trusted contact person (TCP) age 18 or older. FINRA Rule 4512 also describes the circumstances in which firms and their associated persons are authorized to contact the TCP and disclose information about the customer account.
· Has your firm established an adequate supervisory system, including WSPs, related to seeking to obtain and using the names and contact information for TCPs?
· Does your firm educate registered representatives about the importance of collecting and using trusted contact information, where possible?
· No Reasonable Attempt to Obtain TCP Information – Not making a reasonable attempt to obtain the name and contact information of a TCP for all non-institutional customers (e.g., seeking to obtain this information only from senior non-institutional customers, not requesting this information within firm’s regularly scheduled 36-month customer account records update letter).
· No Written Disclosures – Not providing a written disclosure explaining the circumstances under which the firm may contact a TCP when seeking to obtain TCP information (e.g., when a new non-institutional account is opened or when the firm updates an existing account’s information (in accordance with FINRA Rule 4512(b))).
· Training – Conducting training, for both front office and back office staff, on the warning signs of potential: (1) customer exploitation; (2) diminished capacity; and (3) fraud perpetrated on the customer.
· Emphasizing the Importance of TCP and Promoting Effective Practices –
o Emphasizing at the senior-management level on down the importance of collecting TCP information.
o Using innovative practices, such as creating target goals for collecting TCP and internally publicizing results among branch offices or regions.
o Promoting effective ways of asking for TCP information and seeking feedback from registered representatives and supervisors on techniques that they have successfully used that have not already been publicized across the organization.
o Establishing a system that notifies registered representatives when accessing non-institutional customer accounts that do not have a TCP listed and reminds them to request that information from customers.
· Senior Investor Specialists – Establishing specialized groups or appointing individuals to handle situations involving elder abuse or diminished capacity; contact customers’ TCPs—as well as Adult Protective Services, regulators and law enforcement, when necessary—and guiding the development of products and practices focused on senior customers.
· Firm Outreach – Hosting conferences or joining industry groups focused on protecting senior customers.
Funding Portals and Crowdfunding Offerings
Title III of the Jumpstart Our Business Startups (JOBS) Act enacted in 2012 contains provisions relating to securities offered or sold through crowdfunding. The SEC’s Regulation Crowdfunding and FINRA’s corresponding set of Funding Portal Rules set forth the principal requirements that apply to funding portal members.
Funding portals must register with the SEC and become a member of FINRA. Broker-dealers contemplating engaging in the sale of securities in reliance on the crowdfunding exemptions must notify FINRA in accordance with FINRA Rule 4518 (Notification to FINRA in Connection with the JOBS Act).
· What steps is your firm taking to confirm all required issuer information, pursuant to Regulation Crowdfunding Rules 201 and 203(a), is publicly available on your firm’s platform?
· Does your firm plan to undergo or has it already undergone an operational or structural change that impacts the capitalization of the firm, pursuant to Funding Portal Rule 110(a)(4)? Has your firm reviewed the membership rules to confirm a Continuing Membership Application (CMA) is not required?
· Failure to Obtain Attestation – Not obtaining the attestation required by Regulation Crowdfunding Rule 404 when using a third-party vendor to store the required records.
· Missing Disclosures – Offerings on the platform do not contain all required disclosures as codified in Regulation Crowdfunding, in particular:
– names of officers and directors of the issuer, and the positions held by these individuals for the past three years;
– descriptions of the purpose and intended use of proceeds, the process to complete the offering transaction or cancel an investment commitment, the ownership and capital structure, the material terms of any indebtedness of the issuer; and
– financial statements, as required by Regulation Crowdfunding Rule 201(t).
· Failure to Report Customer Complaints – Not reporting written customer complaints, as required by FINRA Funding Portal Rule 300(c).
· Untimely Required Filings – Not making required filings in a timely manner—such as filing the funding portal’s Statement of Gross Revenue by the deadline of March 1—and not filing updates or changes to contact information within 30 days of the change.
· Not Filing CMAs – Funding portals effecting changes in ownership without obtaining prior approval from FINRA, as required by Funding Portal Rule 110(a)(4).
· Compliance Resources – Developing annual compliance questionnaires to verify the accuracy of associated persons’ disclosures, including follow-up questions (such as whether they have ever filed for bankruptcy, have any pending lawsuits, are subject to an unsatisfied judgments or liens or received any written customer complaints), as well as compliance checklists and schedules to confirm that required obligations are being met in a timely manner, such as providing all issuer disclosure requirements of Regulation Crowdfunding Rule 201.
· Supervision – Implementing supervisory review procedures tailored to funding portal communications requirements that, for example, clearly define permissible and prohibited communications and identify whether any contemplated structural or organizational changes necessitate the filing of a CMA.
Disclosure of Routing Information
Rule 606 of Regulation NMS requires broker-dealers to disclose information regarding the handling of their customers’ orders in NMS stocks and listed options. These disclosures are designed to help customers: better understand how their firm routes and handles their orders; assess the quality of order handling services provided by their firm; and ascertain whether the firm is effectively managing potential conflicts of interest that may impact their firm’s routing decisions.
· Does the firm publish accurate, properly formatted quarterly routing reports on its website for the required retention period as specified under Rule 606(a), including use of the SEC’s most recently published PDF and XML schema?
· If the firm is not required to publish a quarterly report under Rule 606(a), does the firm have an effective supervisory process to periodically confirm that the firm has no orders subject to quarterly reporting?
· If the firm routes orders to non-exchange venues, does the firm adequately assess whether such venues are covered under Rule 606(a)?
· If the firm routes orders to non-exchange venues, does the firm obtain and retain sufficient information from such venues to properly report the material terms of its relationships with such venues, including specific quantitative and qualitative information regarding PFOF and any profit-sharing relationship?
· If the firm claims an exemption from providing not held order reports under Rule 606(b)(3) pursuant to Rule 606(b)(4) or (5), what policies and procedures does the firm have in place to determine if the firm’s or a customer’s order activity falls below the relevant de minimis thresholds?
· If the firm is required to provide customer-specific disclosures under Rule 606(b)(3), does the firm provide accurate, properly formatted disclosures for the prior six months to requesting customers within seven business days of receiving the request?
· Inaccurate Quarterly Reports – Publishing inaccurate information in the quarterly report on order routing, such as:
o reporting only held orders in listed options, instead of both held and not held orders;
o incorrectly stating that the firm does not have a profit-sharing arrangement or receive PFOF from execution venues;
o not including payments, credits or rebates (whether received directly from an exchange or through a pass-through arrangement) in the “Net Payment Paid/Received” and “Material Aspects” sections of the quarterly report;
o not including exchange pricing arrangements (e.g., tiered pricing) in the “Net Payment Paid/Received” and “Material Aspects” sections of the quarterly report;
o not disclosing any amounts of “Net Payment Paid/Received”, when the firm receives PFOF for at least one of the four order types (i.e., Market Orders, Marketable Limit Orders, Non-Marketable Limit Orders, Other Orders);
o inaccurately identifying reported execution venues as “Unknown”;
o inaccurately identifying firms as execution venues (e.g., identifying routing broker-dealer as execution venue, rather than the exchange where transactions are actually executed);
o incorrectly listing an entity as an execution venue when that entity does not execute trades (e.g., firm that re-routes, but does not execute, orders; options consolidator that does not provide liquidity); and
o not posting the quarterly report on their firm’s website in both required formats (i.e., PDF and XML schema).
· Incomplete Disclosures – Not adequately describing material aspects of their relationships with disclosed venues in the Material Aspects disclosures portion of the quarterly report, such as:
o inadequate descriptions of specific terms of PFOF and other arrangements (e.g., “average” amounts of PFOF rather than specific disclosure noting the payment types, specific amount received for each type of payment, terms and conditions of each type of payment);
o ambiguous descriptions of receipt of PFOF (e.g., firm “may” receive payment);
o inadequate or incomplete descriptions of PFOF received through pass-through arrangements;
o incomplete descriptions of exchange credits or rebates; and
o incomplete descriptions of tiered pricing arrangements, including the specific pricing received by the firm.
· Deficient Communications – Not notifying customers in writing of the availability of information specified under Rule 606(b)(1), as required by Rule 606(b)(2).15
· Insufficient WSPs – Either not establishing or not maintaining adequate WSPs reasonably designed to achieve compliance with the new requirements of Rule 606, including:
o not updating their Disclosure of Order Routing Information WSPs to include new requirements detailed in amended Rule 606(a)(1) or new Rule 606(b)(3);
o not describing the steps taken to review whether firms verified the data integrity of information sent to, or received from, their vendor—or not stating how the review would be evidenced by the reviewer;
o not articulating a supervisory method of review to verify the accuracy, format, completeness, timely processing and details of the new Rule 606(b)(3) report, if requested, as well as documenting the performance of that review; and
o not requiring the inclusion of detailed information regarding the routing and execution of the firm’s customers’ listed options orders in quarterly reports or customer-requested order routing disclosures.
· Supervision – Conducting regular, periodic supervisory reviews of the public quarterly reports and customer-specific order disclosure reports, if applicable, for accuracy (e.g., assuring that per-venue disclosures of net aggregate PFOF and other payments are accurately calculated) and completeness (e.g., assuring that the Material Aspects section adequately describes the firm’s PFOF and other payment arrangement for each execution venue, including all material aspects that may influence the firm’s order routing decisions).
· Due Diligence on Vendors – Performing due diligence to assess the accuracy of public quarterly reports and customer-specific order disclosure reports provided by third-party vendors by, for example, holding periodic meetings with vendors to review content of reports, comparing order samples against vendor-provided information, and confirming with the vendor that all appropriate order information is being received (particularly when the firm has complex routing arrangements with execution venues).
Portfolio Margin and Intraday Trading
FINRA Rule 4210(g) (Margin Requirements) permits member firms to apply portfolio margin requirements—based on the composite risk of a portfolio’s holdings—in margin accounts held by certain investors as an alternative to “strategy-based” margin requirements. Firms are required to monitor the risk of the positions held in these accounts during a specified range of possible market movements according to a comprehensive written risk methodology.
· Do the firm’s policies and procedures for monitoring the risk of their investors’ portfolio margin accounts comply with Rule 4210(g)(1), in particular:
o maintaining a comprehensive written risk methodology for assessing the potential risk to the member’s capital during a specified range of possible market movements of positions maintained in such accounts;
o monitoring the credit risk exposure of portfolio margin accounts both intraday and end of day; and
o maintaining a robust internal control framework reasonably designed to capture, measure, aggregate, manage, supervise and report credit risk exposure to portfolio margin accounts?
· Inadequate Monitoring Systems – Systems not designed to consistently identify credit risk exposure intra-day (e.g., do not include defined risk parameters required to produce
notifications or exceptions reports to senior management; require manual intervention to run effectively) or end of day (e.g., cannot monitor transactions executed away in a timely manner).
· Not Promptly Escalating Risk Exposures – Staff failing to promptly identify and escalate incidents related to elevated risk exposure in portfolio margin accounts to senior management, in part due to insufficient expertise.
· Insufficient WSPs – Failing to maintain written supervisory procedures outlining intraday monitoring processes and controls.
· Internal Risk Framework – Developing and maintaining a robust internal risk framework to identify, monitor and aggregate risk exposure within individual portfolio margin accounts and across all portfolio margin accounts, including:
o increasing house margin requirements during volatile markets in real-time;
o conducting stress testing of client portfolios;
o closely monitoring client fund portfolios’ NAV, capital, profitability, client redemptions, liquidity, volatility and leverage to determine if higher margin requirements or management actions are required; and
o monitoring and enforcing limits set by internal risk functions and considering trigger and termination events set forth in the agreement with each client.
· Concentration Risk – Maintaining and following reasonably designed processes (reflected in the firm’s WSPs) and robust controls to monitor the credit exposure resulting from concentrated positions within both individual portfolio margin accounts and across all portfolio margin accounts, including processes to:
o aggregate and monitor total exposure and liquidity risks with respect to accounts under common control;
o identify security concentration at the aggregate and single account level; and
o measure the impact of volatility risk at the individual security level.
· Client Exposure – Clearly and proactively communicating with clients with large or significantly increasing exposures, according to clearly delineated triggers and escalation channels established by the firm’s WSPs; and requesting that clients provide their profit and loss position each month.