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FINRA and the SEC published their annual Risk Monitoring and Examination Reports highlighting the focus areas that member firms will be evaluated on this year. We will cover several focus areas as well as fines that the two regulators levied on their members in Q4 2020, and discuss trends for 2021.
The Financial Industry Regulatory Authority (FINRA) and the Securities and Exchange Commission (SEC) recently published their annual Risk Monitoring and Examination Activities Reports highlighting this year’s focus areas that member firms will be evaluated on. Several priorities to look out for include: Anti-Money Laundering, Best Execution, Fintech and Cryptocurrency, as well as Supervision. Many of the exam priorities for 2021 stem from recent exam findings and enforcement actions from the two regulatory bodies.
In this article, we have covered several key priorities as well as fines that two of the nation’s most prominent securities regulators levied on their members in the fourth quarter of 2020, and how firms’ compliance departments should be mindful of these new developments in 2021. Then, we have highlighted macro-level trends that will affect the regulatory space in the coming year. Keeping the priorities and trends in mind will help firms continue adjusting their compliance and regulatory risk programs.
Anti-Money Laundering (AML) is being prioritized by both the SEC and FINRA. The Bank Secrecy Act requires broker-dealers and registered investment companies to establish AML programs that are tailored to address the risks associated with the firm’s location, size, and activities. FINRA’s Rule 3310 requires that members develop and implement a written AML program reasonably designed to comply with the requirements of the BSA and its implementing regulations.
FINRA is focusing on its Rule 2330, which states that a member is required to have a reasonable belief that the customer has been informed of the various features of annuities, and that the member has taken the necessary efforts to determine the customer’s age, annual income, investment experience, investment objectives, investment time horizon, existing assets, and risk tolerance. FINRA includes effective practices regarding Buyout Offers and Exchanges, highlighting measures that a firm can have in place to avoid getting fined for lack of supervision over its Variable Annuities.
Neither the SEC nor FINRA are listing Supervisory deficiencies and practices as separate priorities but are addressing them as part of the underlying regulatory obligation to customers in light of the pandemic. Firms will continue to have a large remote footprint and thus may increasingly utilize new communication technologies, develop new workflows around onboarding customers, as well as expand (and in some cases close) business lines, or offer different products and services.
FINRA is focusing on its Rule 5310 that states that in any transaction for or with a customer
or a customer of another broker-dealer, a member shall use reasonable diligence to ascertain the best market for the subject security, and buy or sell in such a market so that the resultant price to the customer is as favorable as possible under prevailing market conditions. FINRA provides members with effective practices like Exception Reports and Payment-for-Order-Flow Impact Reviews to aid in the avoidance of getting fined for violations related to Best Execution. The SEC makes it clear throughout its Exam Priorities that it will continue to prioritize Best Execution obligations throughout its examinations this year.
Both regulatory authorities were careful in their verbiage this year to avoid making any mention of “cryptocurrencies”. As a result, the SEC opted to use words like “digital assets” and “distributed ledger technology” to shed light on the topic, and to inform its members that it has begun assessing the effect of these digital assets on the following: (1) whether investments are in the best interests of investors; (2) portfolio management and trading practices; (3) safety of client funds and assets; (4) pricing and valuation; (5) effectiveness of compliance programs and controls; and (6) supervision of representatives’ outside business activities. And now, with Gary Gensler’s confirmation as the new Chairman of the SEC, we expect a more pragmatic approach to cryptocurrency regulation. Mr. Gensler is crypto literate, and his bullish outlook on the digital asset industry coupled with his duty to protect the investing public, will likely lead the SEC to take a head-on approach to cryptocurrency markets regulation.
One of FINRA’s largest fines of the last six months comes from cracking down on one firm’s lack of supervision of its representatives. Even though commissions from the sale of variable annuities (VAs) accounted for over 40% of this firm’s revenues, this broker-dealer failed to provide the proper guidance to its representatives on how to advise the right VA for its customers. This resulted in representatives taking advantage of the commission-based pay structure and recommending the improper VAs to customers. The firm didn’t have a supervision system in place to detect when representatives were overstating benefits of some VAs, and failed to establish a system to verify whether waivers were properly applied, leading to over a $400k overstatement of revenues.
With an adequate supervision system in place, this Broker Dealer could have saved itself millions of dollars in fines as well as long-term reputational damage associated with mistreatment of clients.
As evidenced by two of the largest fines handed down by the SEC in Q4 2020, The Commission is making a concerted effort to disincentivize broker-dealers from exploiting the usage of 12b-1 fees to compensate their brokers. Firms have been advising clients to purchase mutual funds that pay out commissions in the form of 12b-1 fees, without outwardly acknowledging that as the reason for why those particular mutual funds were recommended. Additionally, companies have been recommending mutual fund share classes that pay out 12b-1 fees when more favorable/better performing share classes of the same funds were available.
Compared to Q3 2020, where all the firms that were fined were small/middle-market, the transgressors this quarter were two of the largest brokerage firms in the country, with their combined fines totalling more than $50 Million. The SEC acknowledges that this has been an ongoing issue, and is handing out much larger fines than in years past. It will be interesting to witness the industry’s response to the fines, and whether it will be enough to deter firms from engaging in such practices.
One of the largest mobile stock-trading and investing apps was fined $65 Million for misleading revenue sources and failing to satisfy Duty of Best Action. Between 2015 and 2018, the firm made misleading statements and omissions in customer communications, including in FAQ pages on its website, about its largest revenue source when describing how it made money - namely, payments from trading firms in exchange for the firm sending its customer orders to those firms for execution, also known as 'payment for order flow'.
A prominent selling point to customers was that trading was commission-free; but due in large part to its unusually high payment for order flow rates, the firm’s customers' orders were executed at prices that were inferior to other brokers' prices. Despite this, the company falsely claimed in a website FAQ that its execution quality matched or beat that of its competitors. The order found that the firm provided inferior trade prices that in aggregate deprived customers of $34.1 million, even after taking into account the savings from not paying a commission.
The Financial Crimes Enforcement Network (FinCEN) imposed one of its harshest fines ever in reprimanding a large bank holding company for violating terms of the Bank Secrecy Act. From 2008 to 2014, the firm “willfully failed to establish and maintain an effective Anti-Money Laundering (AML) program to guard against money laundering within the [Check Cashing Group (CCG) unit].” Additionally, the firm “failed to accurately and timely file suspicious activity reports (SARs) on suspicious transactions associated with the CCG.”. Lastly, it “negligently failed to timely file currency transaction reports (CTRs) for the CCG.” All these violations combined resulted in the failure to report millions of dollars in suspicious transactions, “including proceeds connected to organized crime, tax evasion, fraud, and other financial crimes laundered through the Bank into the U.S. financial system.”
Had the bank instituted a robust AML compliance program, it could have saved itself millions of dollars in fines. A robust AML compliance program, in addition to tools (like Artificial Intelligence [A.I.]) can help a bank stay on top of ever evolving regulations in the AML space. The use of A.I. in AML and sanctions-related compliance programs can identify patterns and connections in large datasets that a human would not be able to. Through consistent, long-term use, the A.I. system could also learn and improve pattern detection which would ultimately improve efficiency and accuracy.
Although financial services regulations did not receive a large amount of attention or interest during the 2020 campaign season, the Biden-Harris Administration could have a significant impact on the financial services compliance landscape. Given that the incoming administration will have to co-exist with a closely divided Senate, significant legislative reform may be difficult and time-consuming to advance. However, several key Biden appointees for regulatory positions will largely impact the agenda. Historically, Democrats have held views consistent with more regulations in favor of governing consumer protection, oversight and support for smaller financial institutions. In support of smaller financial institutions, the Biden administration is likely to support up-and-coming fintech firms that are at the forefront of developing unique, innovative financial products and services as they explore and evolve from their own infancy, while ensuring consumers are sufficiently protected. Additionally, key Biden regulatory appointees will likely have “full plates” in their first few months as they must also navigate the cryptocurrency boom and the associated regulations in the space.
Since the boom & crash of 2017, cryptocurrencies such as Bitcoin and Ethereum, for example, have become a much more prevalent part of the mainstream in financial services. Recently, over the past several quarters, cryptocurrencies have been again reaching new all-time highs. With these record highs comes an increased interest in cryptocurrencies from large financial institutions and asset managers, which has consequently also garnered the attention of regulators. Due to the infancy of cryptocurrencies as tradable assets along with the sudden boom in their popularity, many regulators were caught off-guard.
Recently, however, the SEC released a statement  regarding a time-limited relief for cryptocurrency custodians operating as broker-dealers amid industry requests for guidance. Per the proposal, “the SEC’s position in this statement is premised on a broker-dealer limiting its business to digital asset securities to isolate risk and having policies and procedures to, among other things, assess a given digital asset security’s distributed ledger technology and protect the private keys necessary to transfer the digital asset security.”
Prior to this guidance, the SEC & FINRA have previously stated that there are questions about whether digital asset custodians can effectively comply with the Customer Protection Rule, a part of the Securities Exchange Act of 1934 that requires broker-dealers “to promptly obtain and thereafter maintain physical possession or control of all fully-paid and excess margin securities it carries for the account of customers.”  However, many within the industry see this new guidance as a step in the right direction as it is enabling rather than restrictive. Additionally, the SEC has also said this five-year period will give the agency a chance to better understand how it can properly regulate the space.
With the unprecedented success of cryptocurrency trading in recent years, large banks have begun diversifying their assets into crypto. Given the infancy of crypto and its lack of governmental regulation, it is very important for the SEC to establish some sort of governance over the ways in which banks are utilizing it. In Q4 2020, there was a multi-national quant firm that was caught by the Commission for fraudulently diversifying its assets into crypto, when in reality that money was used for personal purposes or other undisclosed high-risk investments.  As this is an ongoing investigation, no penalties have been handed out yet. Firms considering capitalizing on cryptocurrency’s recent success must be aware that the SEC is paying particular attention to this space, and that it is unwise to believe that fraudulent activity will go undetected. As discussed above, Mr. Gensler’s confirmation as Chairman of the SEC will likely have a profound impact on the cryptocurrency landscape, along with the rest of the capital markets industry in the US.
Sia Partners has experience guiding firms through planning for Supervision and AML best practices, auditing firms’ Best Execution guidelines, and an Operational Resilience offering that assists firms in developing a plan for mitigating risks related to the lack of representative supervision. If you’d like to learn more about any topic listed in this article, please reach out to any of our Subject Matter Experts using the contact form below.