Alert
Financial Institutions Law Alert
12.14.2020

On December 9, 2020, the SRO and States Sub-Committee of the ABA Securities Litigation Committee hosted a virtual panel discussing new developments in FINRA Enforcement in 2020. The Panel consisted primarily of representatives from FINRA Enforcement, including: Lara Thyagarajan, Senior Vice President & Head of Market Regulation Enforcement and Litigation, Tina Gubb, Chief Counsel, Market Regulation Enforcement, Jackie Wells, Senior Counsel, Department of Enforcement, Kevin Hartzell, Director, Sales Practice Enforcement, and William Thompson, Director, Department of Enforcement. The Industry was represented by  Eric Bernstein from UBS Financial Services, and Christian Cannon from AXA Equitable Life Insurance Company. The Panel was moderated by Andrew W. Sidman, Principal at Bressler, Amery & Ross, P.C.

The Panel began with a brief discussion of FINRA’s transition during the pandemic to working remotely.  Lara Thyagarajan explained that FINRA’s transition has been successful and FINRA has been able to conduct disciplinary hearings, appeals and OTRs virtually as well as adapt electronic signatures in place of ink signatures among other adaptations.  Next, the Panel provided valuable insights into several current developments of the field. The topics and key points covered are summarized below.

I. Regulation Best Interest

The Panel addressed the distinction between FINRA’s Suitability Rule (Rule 2111) and the new obligations set forth by the Regulation Best Interest (Reg BI) standard, or SEC Rule 15I-1. FINRA Rule 2111 requires a reasonable basis for all recommendations, customer-specific suitability, and quantitative suitability. Reg BI, on the other hand, requires that broker-dealers satisfy four obligations: disclosure, care, conflict of interest, and compliance. The Care Obligation requires that, when recommending a transaction or investment strategy, the firm must exercise reasonable diligence, care, skill and prudence to understand the potential risks and rewards of the recommendation to form a reasonable belief that it is in the best interest of the client. The financial advisor must also consider reasonable alternatives and potential costs of the recommendation. In particular, the firm must consider whether recent transactions taken together are excessive, even if each transaction alone is in the customer’s best interest.

The Panel highlighted that Rule 2111 and Reg BI differ in that Reg BI requires certain express considerations, namely cost and deliberation on reasonable alternatives. These considerations raise questions of how firms can best show and document their deliberation process to support their recommendations. While Reg BI has no express documentation requirement as part of the care obligation, a paper trail might be a best practice.

Applying this obligation to complex products presents challenges as the FINRA Enforcement representatives on the panel felt that such products tend to be misunderstood in the field, often based on their imbedded features and unpredictable behavior. A good example is with leveraged and inverse ETF, which have had a recent resurgence in enforcement actions despite the existence of guidance dating back more than ten years. For example, in a May 2020 settlement involving inverse and leveraged ETFs, FINRA found registered representatives did not fully understand the products, perform suitability analyses, monitor the suitability of holding periods, or generate exception reports for the holding periods. Despite these violations, the relevant firm proactively paid restitution before the decision, causing the commission to demand a relatively small fine.

So how can firms reduce the regulatory and litigation risks of complex products? After FINRA Regulatory Notice 12-03 in 2012, firms began to treat inverse products differently. However, recent enforcement actions by FINRA demonstrate that trouble comes to those firms leaving the analysis of special risks of complex products to financial advisors alone.

According to the SEC OCIE, firms should have dynamic processes to review and monitor complex products rather than static processes like solely monitoring those products with specific FINRA regulatory guidance. Dynamic processes require firms to anticipate other complex products. Once a firm designates a product as complex, it should require financial advisors to participate in specific training targeted to the risks of that particular product, including the firm’s own thinking on the risks of the product. Firms should also put in place checks to make sure the training requirement is functioning in a way that prevents trades from being placed where training has not been completed.

Some firms have also created exception reports to notify advisors when an investment hits or exceeds the desired holding period. Another option for firms is to use a committee to review products prior to permitting them on their platform. These committees are typically comprised of business, legal, and compliance members. A practice pointer from the Panel included that the legal team should be made multi-dimensional by involving litigators and product specialists to combine knowledge of future litigation risks with that of the products themselves.

Completing look-backs after the sale of complex products can help firms determine how much they are selling, to whom, the concentration of the product, and whether there are relevant customer complaints. Firms should review the product’s performance to ensure it conforms with the way it was advertised in the prospectus and how the firm’s training predicted it would perform. The Enforcement staff highlighted a recent settlement involving volatility ETFs to demonstrate that look-back protocols during the product vetting process can help firms keep track of risks and performance issues over time.

The Panel briefly highlighted that conduit municipal offerings can be more complicated than they appear and representatives need to have an understanding of what is underlying the offering because it can change the level of risk.

II. Mutual Funds

The Panel next looked at mutual funds, another recent focus of FINRA Enforcement, by examining a recent settlement. This settlement involved a firm which allowed representatives to apply rights of reinstatement privileges on mutual fund holdings. The mistakes in the application of such rights underscored the need in such situations for firms to reasonably design monitoring systems that are tailored to the catch potential mistakes made by representatives. This settlement also featured extraordinary cooperation demonstrated by the firm’s quick identification of those harmed and provision of restitution. The Panel highlighted that this swift action to provide restitution resulted in FINRA not imposing a fine, underscoring the importance of firm proactivity. This case also tied in with FINRA initiatives to encourage firm cooperation including a January 2019 initiative to encourage firms to volunteer information in exchange for credit pertaining to 529 plans.

The Panel quickly noted that in the last month, FINRA has also announced a targeted examination regarding rights of reinstatement and the letter that details the areas FINRA will ask firms about.

III. Seniors/Vulnerable Investors

The Panel next addressed another key priority of FINRA: the protection of senior and vulnerable investors.  In October 2020, FINRA issued Regulatory Notice 20-38 adopting Rule 3241, limiting a registered person’s ability to be a customer’s beneficiary or hold a position of trust for a customer. This rule (1) imposes the obligation on representatives to provide written notice to the firm of such a relationship, and (2) imposes on the firm the obligation to review those situations to approve or disapprove. In the event a firm approves, the firm then must consider whether to place restrictions on the relationship. If the firm does impose restrictions on the relationship, then it is obligated to supervise the relationship.

From the firm perspective, most firms already have systems in place addressing this topic. Firms generally have a presumption to disallow such relationships except in limited and extraordinary circumstances to avoid potential issues and unnecessary monitoring obligations.

IV. Best Execution

Next, the panel turned to market regulation and best execution.  The Enforcement staff discussed the increasing importance of the best execution examination program in light of the shift to a zero commission retail model. The FINRA staff emphasized that there is nothing inherently wrong with the payment for order model, but it does raise heightened considerations for when payment for order flow could become a potential conflict. FINRA wants firms to examine where they can get better execution quality – whether in terms of price or speed of execution. FINRA will ask for information on regular and rigorous review of executions and prefers when firms are able to document their process and supervisory system.

FINRA has also focused on the revenue streams for firms participating in the zero commission strategy now that such firms are not charging commissions.  The Panel examined one recent settlement where the firm was routing orders to four different wholesale execution centers that were also paying for the routing. FINRA found that while the firm conducted reviews of execution quality at those four wholesalers, it did not look beyond those four to find price improvement opportunities for their customers and thus was not conducting the requisite review.

V. Market Access

The Exchange Act Rule 15c3-5 (the “Market Access Rule”) requires firms that provide access to trading in securities in an ATS or exchange to incorporate appropriate controls to mitigate key risks in accordance with their gatekeeper function. Enforcement actions have been common in the area of unreasonable financial risk controls, such as capital controls or credit limits of customers, particularly where firms are not able to justify where a control or limit came from. As automated and high-speed trading becomes more prevalent in the market, the controls required by the market access rule will continue to be a major focus of the regulator.

Final FINRA Lessons from the Field:

  1. When defense counsel or a firm receives a broad or burdensome letter, they should call the commission to discuss why they feel that way and potentially strike some middle ground.
  2. Communication should be early if counsel has concerns about their ability to respond rather than wait until the deadline to ask for an extension.
  3. Engage in frank conversations with the staff to verify what FINRA is looking for, particularly because FINRA may not understand the firm’s record-keeping practices or investigation process in the preliminary stages.
  4. Avoid rushing to finish up 8210 responses when there is still more work to be done as accuracy is important and errors undermine the Staff’s confidence in the people responding.
  5. If defense counsel does not fully understand the client’s systems and procedures, it can be helpful to put the enforcement attorney in contact with someone from the firm that understands the system to shorten the process a bit.
  6. During the Wells process, it can also help if a firm’s response provides the firm’s perspective on why FINRA would lose if they chose to litigate the case rather than tell FINRA what they are already know and how they have already framed the issues.
  7. Develop trust through dialogue along the way, both by communicating early and often as well as through transparency and accuracy in the work product.

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