FINRA’s 2013 Regulatory Priorities

On January 16, 2013, FINRA Chairman and CEO, Richard Ketchum, spoke at the SIFMA Compliance and Legal Society monthly luncheon about FINRA’s regulatory plans and priorities for the upcoming year.  As set forth below, Mr. Ketchum covered topics that were previously identified by FINRA in its 2013 Regulatory and Examinations Priorities letter, which can be found here, and other significant regulatory issues about which member firms should be cognizant.

Complex Products Remain At The Forefront

Consistent with FINRA pronouncements in recent years, Mr. Ketchum opened his remarks by explaining that FINRA continues to be concerned about the suitability of complex products.  He noted that FINRA has focused on this area, both by publishing notices to members and initiating actions against member firms in connection with such products.  Mr. Ketchum also recognized, however, that not all complex products fall into the same category, e.g., steepeners, reverse convertibles and exchange-traded products.  He also acknowledged that in today’s low-interest-rate environment, it is difficult for advisors to meet client expectations with ordinary fixed-income securities.  This has resulted in a fundamental shift in the risk/reward formula as advisors have, in certain situations, distributed their clients’ investments into more-concentrated and potentially higher-yielding positions; often utilizing complex and less transparent products to chase yield.

Mr. Ketchum offered advice to both counsel and compliance officers alike, suggesting the need for dialogue with the business side to ensure: (1) that member firms are comfortable with their advisors’ understanding of the products they are selling; and (2) that the advisors are able to effectively and appropriately communicate the requisite information to their clients.  For example, Mr. Ketchum explained that structured products “need to feel different from traditional products,” and that firms should consider requiring advisors to memorialize their reasons for believing that a particular product is suitable for an investor and that the investor understood the downside risks.  Mr. Ketchum added that this “think about it” approach would “create an important cultural shift and a better environment for compliance oversight.”

Structured Products

Mr. Ketchum noted that risk disclosures related to structured products have been much improved in recent years.  But, on the other hand, the training and education of advisors seems to have “fallen through the cracks.”  As a result, advisors might not accurately convey to investors the actual risk profile of structured products.  Mr. Ketchum noted that the same “care and commitment” taken to create and approve structured products should extend to the marketing of such products.  He stressed that FINRA’s focus in 2013 is squarely on the sales and distribution of structured products, and whether advisors adequately communicate the risks and potential scenarios of the products to investors.

Exchange-Traded Funds And Products

Mr. Ketchum again focused on the training and education of advisors, and how effectively advisors are able to explain the range of exchange-traded products and funds to their clients.  Advisors have demonstrated all too often that they do not necessarily understand the underlying esoteric indices to which these products may be linked, or that the products may be illiquid.  They, therefore, fail to adequately communicate the various risks to prospective investors.

High-Yield Securities

In today’s market environment, Mr. Ketchum stated that the potential upside of high-yield securities is considerably less than in recent history, which has led investors to press their advisors for higher returns and caused higher-credit-risk companies to issue dubious debt with potentially higher yields.  The result is a shift toward non-investment grade securities being sold to investors with lower risk tolerances.  Mr. Ketchum opined that we are in the midst of a market cycle during which we should expect to see high-yield investments begin to default and underperform dramatically within the next several years.  While noting that there is nothing per se problematic with high-yield securities, assuming the risks are disclosed, Mr. Ketchum advised that member firms need to focus on suitability and concentration, and whether traditional financial products would be more appropriate for the investor, especially for those who require liquidity.

Non-Traded REITs And Closed-End Funds

These securities appear attractive to investors in a low-yield environment.  FINRA is concerned that investors may not understand that initial high-yielding distributions are “teasers” and that the sales costs associated with these products may erode principal.  Firms, therefore, should closely monitor the suitability of these investments and pay close attention to the information that advisors are communicating to investors.

Focus On Private Placements

Mr. Ketchum emphasized that private placements will be a “major focus” for FINRA this year. FINRA Rule 5123, effective as of December 3, 2012, requires, among other things, that member firms submit to FINRA any private placement offering documents used in connection with such sale within 15 calendar days of the date of first sale or indicate to FINRA that no offering documents were used.  Such submissions will allow FINRA to have a better grasp of private placement offerings in the marketplace.

Mr. Ketchum remarked that private placement documents have historically been prone to containing poor disclosures and often contain inadequate explanations regarding investment proceeds.  When selling private placements, firms’ compliance areas should engage in more proactive conversations with business personnel to ensure proper due diligence and that appropriate disclosures are being provided to investors.  Mr. Ketchum noted that firms: (1) have due-diligence obligations irrespective of their underwriter status; and (2) are expected to ask questions to satisfy their due-diligence obligations.  These obligations are heightened when a relationship exists between the firm and the issuer, or where the deal appears on its face to involve a conflict.

Handling Conflicts Of Interest

Mr. Ketchum advised that FINRA plans to take a closer look at how member firms deal with internal conflicts of interest, such as those that may exist between retail and investment banking clients of a firm.  In particular, FINRA’s focus will be on: (1) how member firms view, prioritize, and deal with conflicts; (2) whether conflicts are dealt with in one central location or diversified across different firm departments; and (3) who at a firm is held accountable for monitoring conflicts.  FINRA will review how conflicts may impact the firm from a cultural standpoint and how firms mitigate conflict risks.  Mr. Ketchum emphasized that firms must understand how both direct and indirect compensation “incentives” shape the decision making process.  Specifically, compliance officers should build consultative relationships with their business partners and understand which incentives may lead to incorrect decisions.

Mr. Ketchum noted that conflicts are a “living thing” about which firms need to have internal discussions to determine how best they should be addressed.  Firms should identify both who is responsible for dealing with the conflicts and how they are tracked, and document how conflicts can be mitigated.  Mr. Ketchum added that “reasonably” dealing with a conflict, including with properly documented disclosures, would be considered by FINRA as “good oversight” by the firm, but that firms should continue to improve conflicts documentation.  FINRA is preparing for publication in the near future best practices for addressing conflicts.


The JOBS Act (Jumpstart Our Business Startups), which became effective in mid-2012, made equity crowdfunding a possibility, and such crowdfunding falls under FINRA’s jurisdiction.  Mr. Ketchum noted that FINRA is in the process of adopting rules for crowdfunding portals that will focus on broker-dealer affiliates and intermediaries, including who can represent, solicit and promote crowdfunding.  Mr. Ketchum acknowledged that firms will face difficulties regarding crowdfunding oversight. 

New Suitability Rule Guidance And The Rule Review Process

FINRA recently issued FAQs that Mr. Ketchum believes will assist member firms and associated persons and provide clarity about the new suitability rule.  He noted that a broker’s suitability obligations are not triggered until a potential investor becomes a client.  Mr. Ketchum reiterated FINRA’s stance that the rule employs a reasonableness standard with respect to firms’ oversight of trading in client accounts.

With regard to the implementation of new rules, Mr. Ketchum explained that he is trying to build “contrarianism” into FINRA, which will include the hiring of an economist to better ascertain the impact of newly enacted rules.  The review process will include a structured review and survey of firms to assist in determining the effectiveness of major rule enactments.

Consolidated Audit Trail

FINRA will accelerate its efforts in the near term to develop a plan for consolidated audit trails.  Mr. Ketchum noted that input from the industry is important and he wants to set up an industry committee to interact with FINRA.  Mr. Ketchum expects that a final RFP will be issued in the next few months.

High-Frequency Trading

While high-frequency trading remains a top priority for FINRA, Mr. Ketchum noted that FINRA has seen improvements in supervision.  FINRA expects firms to test their trading algorithms and intends to examine how firms conduct such testing.  Mr. Ketchum noted that compliance should be involved with high-frequency trading even though they have not been traditionally involved in the process.  FINRA will continue to look at “kill switches,” whether and how firms are able to revert to traditional trading designs, and the decision-making process when issues arise.

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