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Bates News, Bates Research  |  12-13-18

FINRA Issues 2018 Report on Examination Findings



In its second annual effort to highlight areas of compliance concern, FINRA published a 2018 Report on Examination Findings. The thorough report details selected observations and findings from broker-dealer firm exams that have “potential significance, frequency and impact on investors and the markets.” Last year’s report led with compliance concerns on anti-money laundering, cyber-security, best execution and outside business activities. In retrospect, these areas of focus were a warning of the kinds of enforcement actions regulators would bring throughout 2018.

The primary areas of focus in this year’s report are suitability for retail customers, private placements, abuse of the authority a client gives to a registered representative, and fixed income mark-up disclosure. FINRA also included within the report case studies that highlight examination findings from a targeted examination (sweep) of volatility-linked products. This article takes a closer look at these FINRA priorities—with links to current Bates Research articles on the substantive issues—and additional FINRA findings on compliance issues raised by this year’s examinations.

Suitability for Retail Investors

In the broadest sense, the theme of the FINRA report is a concern for retail investors and the suitability of products and services offered to them. In its examination of broker-dealer firms, FINRA found (i) continuing instances of unsuitable recommendations to retail investors and (ii) “deficiencies in some firms’ supervisory systems for registered representatives’ activities.”  

FINRA found infractions of all three required suitability obligations: reasonable-basis, customer-specific and quantitative suitability. FINRA found instances where registered representatives “did not adequately consider the customer’s financial situation and needs, investment experience, risk tolerance, time horizon, investment objectives, liquidity needs and other investment profile factors when making recommendations.” In other cases, FINRA found failures to “take into account …cumulative fees, sales charges or commissions” and unsuitable recommendations that resulted in excessive trading or overconcentration in certain complex products (including non-traded real estate investment products [REITs]) and “volatility linked products” (such as leveraged and inverse exchange-traded products [ETPs]), illiquid securities, “variable annuities, “switches” between share classes, and Unit Investment Trusts [UITs]).  As to suitability concerns regarding these latter volatility-linked products, FINRA noted challenges with supervisory systems and other operational issues in instances “when a broker-dealer or associated person has ‘actual or de facto control’ over a customer’s account.” In such instances, FINRA reminded firms of recent guidance on bad actors requiring “special supervisory procedures.”

Private Placements

An increasing concern highlighted by the FINRA report is the failure of firms to conduct reasonable diligence and to supervise brokers engaged in private placements. FINRA found that certain firms failed to perform such due diligence prior to recommending private placement offerings to retail investors. FINRA reminded firms of their obligation to conduct a “reasonable investigation” by evaluating “the issuer and its management; the business prospects of the issuer; the assets held by or to be acquired by the issuer; the claims being made; and the intended use of proceeds of the offering.” Such diligence, FINRA said, works to mitigate conflicts, ensures that offerings are suitable for investors and informs appropriate and comprehensive disclosures. FINRA also warned firms not to over-rely on third parties that provide due diligence reports and to watch for conflicts of third-party diligence providers.

Abuse of Authority

FINRA highlighted the risks for retail investors who give registered representatives the authority to act on their behalf to engage in discretionary trading, “to act as trustees or co-trustees, hold Powers of Attorney or serve as executors or beneficiaries.” FINRA warned of the material risk to the retail investor from unsuitable or excessive trading; they found numerous instances where certain firms exposed investors to unnecessary risks and failed to establish controls to mitigate those risks. For example, FINRA found failures in the authorization process to engage in discretionary trading; expired authorizations; mismarked order tickets that obscure unauthorized discretionary trading; failures to comply with securities’ threshold limitations or other trading restrictions; and other intentional deceptions including falsifying authorization and suitability forms and abuse of trustee status when trading in a customer’s account.

Fixed Income Mark-up Disclosure

FINRA also found that firms were facing challenges implementing new FINRA and MSRB rules on fixed income mark-up disclosures. These challenges include putting in place appropriate confirmation review processes, systems and vendors. The new rules require firms to provide transaction-related mark-up or mark-down information to retail customers for certain trades in corporate, agency and municipal debt securities. FINRA found lapses related to inadequate disclosure in Order Entry Systems, inaccurate disclosures on customer confirmations, disclosure failures related to transactions in certain structured notes, incorrect designations of institutional accounts, and assorted vendor related problems. FINRA cautioned that “firms should consider reviewing samples of their confirmations for all of the required disclosure elements, including the mark-up or mark-down, the time of execution” and security-specific links. FINRA said that firms should also consider whether they are maintaining consistent and correct disclosures for fixed income transactions executed across different vendors, platforms or trading desks.

Other Observations

As noted by Susan Schroeder at a recent 2018 SIFMA C&L New York Regional Seminar, FINRA continues to be concerned about compliance challenges on a host of other issues. Here are the ones designated in the report:

AML – FINRA recognized continuing compliance challenges fulfilling anti-money laundering obligations, particularly in light of the May 11, 2018 effective date of FinCEN’s Customer Due Diligence (CDD) rule. FINRA found general inadequacies of certain firms’ overall AML programs: misallocations of AML trade monitoring responsibilities, failures in data integrity in automated surveillance systems, and inadequate resourcing for AML programs, among others.

Net Capital Rule and Liquidity Requirements – FINRA found compliance issues with net capital rules designed to protect against monetary losses in the event of a “broker-dealer failure.” FINRA also found deficiencies with firms’ liquidity risk management programs which are designed to protect customers by ensuring that a firm can continue to operate under “stressed” conditions.”

Segregation of Client Assets – FINRA found that certain firms failed to comply with the Customer Protection Rule, which ensures that customer cash is not intermingled with the firm’s proprietary business activities.

Operations Professional Registration – FINRA found that some firms continued to permit unregistered staff to engage in activities that would require Operations Professional registration.

Customer Confirmations – FINRA found that certain firms did not maintain adequate supervisory programs relating to confirmations or comply with certain confirmation disclosure requirements for transactions in equity securities.

DBAs and Communications with the Public – FINRA found compliance deficiencies related to requirements to maintain controls, provide adequate disclosures, monitor retail communications, websites, social media accounts, seminars and external email accounts used by representatives when communicating on the firm’s behalf.

Best Execution – FINRA found certain firms that receive, handle, route or execute customer orders failed to meet their duty of best execution in equities, options and fixed income securities trading. The deficiencies included failures to perform execution quality assessments in competing markets, failures to conduct adequate reviews on a type-of-order basis, and failures to consider factors like speed of execution, price improvement and the likelihood of execution of limit orders.

TRACE Reporting – FINRA found that certain firms engaging in institutional sales of fixed income securities did not comply with TRACE reporting rule requirements.

Market Access Controls – FINRA found that certain firms failed to maintain effective pre-trade financial controls or make required intra-day adjustments of pre-trade financial thresholds and oversight of third-party vendors.


The 2018 Report on Examination Findings should be reviewed carefully by broker-dealer firms. It is not just a checklist of every compliance item FINRA is currently assessing, it is a warning to firms about what to watch for in terms of regulatory enforcement. Bates will continue to track regulatory alerts and enforcement actions to help you stay ahead of the curve.

For additional information and assistance, please follow the links below to Bates Group's Practice Area pages:

Bates Compliance Solutions

Regulatory and Internal Investigations

Retail Litigation and Consulting

Institutional and Complex Litigation

Financial Crimes

Consulting and Expert Testimony

Contact Bates Group

Bates Group is with you every step of the way. Contact us today for more information on how our End-to-End Solutions can help your firm.