FINRA Eyes Disclosure In Exams

CHICAGO — The Financial Industry Regulatory Authority will soon begin examining underwriters of municipal bonds to see if they can show they have carried out disclosure due-diligence obligations like those in a risk alert the Securities and Exchange Commission issued in March, a senior FINRA official said Wednesday.

Speaking at an industry event here, FINRA associate director of member regulation Cynthia Friedlander said the SEC’s risk alert includes “good information for underwriters about what the SEC will expect when they [review their] due-diligence practices, and by extension FINRA will be looking at the same things.”

“Our concerns are the same as the SEC’s. We are going to be using those best practices to confirm … what other firms are doing,” Friedlander said.

But her comments raised concern from the members of the dealer community, who cautioned the alert contains suggestions, not requirements, under the law.

SEC Rule 15c2-12 on muni disclosure requires that an underwriter, before bidding for or purchasing securities, reviews an official statement that is “deemed final” and “reasonably determines” that the issuer agreed in writing to provide continuing disclosures.

The underwriters must evaluate the issuer’s likelihood of complying with the agreement, review the disclosures for accuracy and completeness, and obtain evidence that the issuer provided annual financial information and notices of certain events that occurred.

In addition, the Municipal Securities Rulemaking Board’s Rule G-27 requires underwriters to maintain supervisory procedures to ensure compliance.

The eight-page “National Examination Risk Alert” that was issued by the SEC’s Office of Compliance Inspections in March reminded underwriters of their disclosure obligations under the rule, and included examples of some practices that firms can adopt to demonstrate compliance.

The examples include maintaining written explanations of regulatory requirements, creating due-diligence and record-keeping checklists, forming committees to ensure compliance and conducting on-site examinations of issuers.

The alert said firms may consider other factors in assessing compliance. Dealers may “identify and implement other practices or controls that they believe are reasonably designed to meet their obligations under the federal securities laws, and the staff’s observations,” it said.

Friedlander said Wednesday that the alert is significant because it “explicitly stated” that the SEC wants underwriters to have written evidence of due diligence.

She said FINRA examiners will compare underwriters’ procedures to the practices in the alert, and clarified that dealers that don’t adopt the practices won’t necessarily violate 15c2-12.

“If you can think of another way to demonstrate that you are in compliance … without documenting that you enforced your procedures, I am willing to hear it,” she said. “I just don’t know how you can make that demonstration short of some sort of … concrete documentation.”

The moderator of the seminar, Leslie Norwood, co-head of the muni division at the Securities Industry and Financial Markets Association, said she has “serious concerns” because Friedlander’s comments suggest FINRA may begin “enforcing the SEC’s risk alert.”

She called the examples in the alert “mere suggestions and not regulations that should be enforced.”

“15c2-12 itself does not have a documentation provision,” she said. “There is a lot of industry concern that it appears FINRA and the SEC are … looking for written evidence of 15c2-12 compliance when the rule itself requires none.”

Norwood added that the alert was not opened for public comment and posted in the Federal Register — steps required for regulations to become adopted.

She expressed fears that documentation will be “retroactively” required by regulators, resulting in “gotcha type of enforcement.”

Susan Axelrod, executive vice president and head of the member regulation sales practice area at FINRA, said: “Alerts communicate best practices and are meant to be helpful to firms but are not regulatory guidelines. Being a proactive and communicative regulator is good for investors and firms.”

Bond Dealers of America chief executive Michael Nicholas said regulators should give dealers leeway to comply with regulations as they see fit.

He cautioned against overly “proscriptive, one-size-fits-all” regulations, noting that firms have varying resources and client bases.

“It should be up to the firm to have their own policies and procedures in place to meet those regulatory obligations,” he said. “One firm can meet compliance guidelines in a different manner than another.”

BDA, in partnership with law firm Nixon Peabody LLP, issued a guidance paper to members in April explaining the alert. The BDA document reminds its members that they may use “other practices or controls” to meet their disclosure obligations.BDA and SIFMA also noted that dealers have little recourse if issuers fail to meet disclosure obligations.

“The underwriter really doesn’t have any control over the issuer or the issuer’s compliance,” Norwood said. “A broker-dealer has its hands tied if the issuer does not disclose adequately.”

Friedlander said FINRA has adopted a “risk-based management” in recent years, which she said will allow the agency to focus enforcement and examination efforts on firms that pose the greatest risks

In December 2011, the MSRB’s Rule G-16 was changed to allow FINRA to conduct examinations once every four years, but some firms more often. Previously, FINRA had inspected firms every two years.

Friedlander said the changes allow the self-regulator to examine riskier firms more frequently. She estimated the agency will examine 600 dealers in 2012, compared to 900 examinations in recent years.

FINRA has flagged about 60 of the highest-risk firms for annual examinations. The remaining firms will be examined at two-, three- or four-year intervals, she said.

Friedlander said examiners will focus on firms’ compliance with rules related to bid-rigging, yield chasing, disclosure, suitability, retail order periods, fair pricing and dealing, and gifts and entertainment.



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