Summary of FINRA Regulatory Actions in Q1 2020

July 9, 2020 by ACA Compliance Group


The Financial Industry Regulatory Authority’s (“FINRA”) Enforcement Division brought 43 enforcement actions and levied fines against member firms that totaled $21,027,000‬‬ in the first quarter of 2020 (Q1 2020). These numbers mark an increase in the enforcement actions but a decrease in the total amount of fines from the first quarter of 2019, as the tables below show.

The largest individual fines in Q1 2020 stemmed from alleged failures related to direct market access and best execution, failure to disclose outside business activities, and failure to supervise custodian accounts. According to FINRA’s disciplinary announcements, nine broker-dealers paid restitutions totaling $16,718,508.

 Q1 2020
Fine Amounts$21,027,000
 # of Fines43

 

 Q1 2019Q2 2019Q3 2019Q4 2019Total 2019
 Fine Amounts$24,484,000$3,645,000$5,985,000$23,867,000$57,981,625
 # of Fines24243228108

 

Direct Market Access (“DMA”)

To mitigate market access risk, the Securities and Exchange Commission (“SEC”) adopted Rule 15c3-5 (“Market Access Rule”) under the Securities Exchange Act of 1934. Rule 15c3-5(b) requires a broker-dealer that has market access, or that provides a customer or any other person with access to an exchange or alternative trading system through use of the broker-dealer’s market participant identifier or otherwise, to establish, document, and maintain a system of risk management controls and supervisory procedures reasonably designed to manage the financial, regulatory, and other risks of this business activity.

On December 23, 2019, FINRA issued a Letter of Acceptance, Waiver, and Consent (“AWC”) against a member for alleged supervisory violations and violations of various Rule 15c3-5 provisions. The AWC stated that the member firm offered its clients direct access to numerous exchanges and alternative trading systems. The firm executed over 300 billion shares on behalf of its DMA clients, generating $300 million in revenue from this business. Some of that trading activity generated over 50,000 alerts at FINRA and other exchanges for potential manipulative trading such as spoofing, layering, wash sales, and prearranged trading. Three of the firm’s DMA clients accounted for most of the 50,000 alerts. The same three clients, at the peak of their activity, accounted for about 20 percent of the firm’s overall order flow.

FINRA alleged that the firm failed to establish, document, and maintain reasonably designed risk management controls and supervisory procedures as required by Rule 15c3-5. FINRA also found that the firm violated numerous other Market Access Rule provisions.

In addition to other sanctions, the firm was censured and fined $6,500,000.

Regarding DMA, FINRA stresses that firms must be aware that the “compliance burden rests with the broker-dealer whose participant identifier is being utilized for access to the markets.” Consequently, firms must establish risk management controls and supervisory procedures that describe how they manage financial, regulatory, and other risks related to providing access.

Best Execution

FINRA Rule 5310 (“Best Execution Rule”) codifies a broker-dealer’s duty of best execution. The rule requires firms to use reasonable diligence to ascertain the best market for the subject security and buy or sell in such market to obtain a price as favorable as possible for the customer under prevailing market conditions. Among the factors to consider in determining whether a firm has used reasonable diligence are these:

  • The character of the security’s market
  • The transaction size and type
  • The number of markets checked
  • The quotation’s accessibility
  • The order terms and conditions as communicated by the customer to the firm and the firm’s associated persons

On December 19, 2019, FINRA issued an AWC against a firm for alleged violations related to its customers’ equity orders and related supervisory failures. FINRA found that the firm routed its customers’ nondirected equity orders to four broker-dealers, all of which paid the violating firm through a “payment for order flow” arrangement. The firm also allegedly failed to 1) reasonably consider the Rule 5310 execution quality factors, 2) perform systematic best execution reviews of several order types, and 3) establish a supervisory system reasonably designed to achieve compliance with its best execution obligations.

The firm consented to, among other sanctions, a censure and a fine in the amount of $1,250,000.

Broker-dealers that route customer orders to other broker-dealers should conduct an order-by-order review. They should also have procedures and policies in place to ensure that they periodically conduct regular rigorous reviews of the execution quality of customer orders.

Outside Business Activity (“OBA”)

Rule 3270 (“Outside Business Activities of Registered Persons”) provides that a registered person cannot engage in an OBA without giving prior written notice to the broker-dealer in the form specified by the broker-dealer. Such OBAs involve acting for another person, as their employee, independent contractor, sole proprietor, officer, director, or partner. They may also include being compensated, or having the reasonable expectation of compensation, from any other person as a result of any business activity outside the scope of the registered person’s relationship with a broker-dealer.

On December 19, 2019, FINRA issued an AWC describing how a registered representative allegedly failed to disclose that he served as a director of a publicly traded company and that he had not obtained approval of this OBA from his firm.

The registered representative was fined $5,000 and suspended from association with any FINRA member for a specified duration.

A broker-dealer must have procedures in place concerning OBAs. These include but are not limited to:

  • setting up a formal process for seeking approval of new outside activity or to approve a new associated person’s existing outside activities
  • reviewing the new activity and its effect on the broker-dealer and its customers
  • conducting periodic internet searches on registered representatives to monitor for unreported OBAs requiring associated persons to report any changes in their activities’ scope or structure

Broker-dealers should evidence all such procedures. They might, for example, maintain a discrete log that includes, among other items, a description of the outside activity, an assessment of whether such activity must be disclosed on Form U4, and documentation of a principal’s approval of the activity.

Supervision of Custodial Accounts

FINRA Rule 2090 (“Know Your Customer”) requires member firms and their associated persons to “use reasonable diligence” to determine the “essential facts” about every customer and “the authority of each person acting on behalf of such customer.” FINRA Rule 2090.01(c) further defines “essential facts” as those required to “understand the authority of each person acting on behalf of the customer.”

FINRA sanctioned five firms in Q1 2020 for allegedly failing to reasonably supervise for compliance with FINRA Rule 2090. The five firms allegedly did not know essential facts about customers with certain custodial accounts. They also allegedly failed to establish, maintain, and enforce reasonably designed supervisory systems and procedures to monitor whether custodians transfer control over custodial property to account beneficiaries in a timely manner.

In addition to other sanctions, the five firms paid combined fines of $1,400,000. They also agreed to review their policies, systems, and procedures to ensure they are reasonably designed to supervise custodial accounts and achieve compliance with FINRA Rule 2090.

Broker-dealer firms should establish reasonable policies and procedures to obtain essential facts about every customer. Essential facts include but are not limited to those required to service the customer’s account effectively, to act in accordance with any special handling instructions, and to comply with applicable regulations. The collection of such information should be completed at the beginning of the customer-broker relationship and continue throughout the relationship.

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