Regulatory Notice 18-15

Summary

FINRA is publishing this Notice to reiterate the supervisory obligations of

member firms regarding associated persons with a history of past misconduct

that may pose a risk to investors. FINRA Rule 3110 (Supervision) requires

member firms to establish and maintain a system to supervise the activities

of each associated person that is reasonably designed to achieve compliance

with applicable securities laws and FINRA rules. An effective supervisory

system plays an essential role in the prevention of sales abuses, and thus,

enhances investor protection and market integrity. As such, FINRA has long

emphasized that member firms have a fundamental obligation to implement

a supervisory system that is tailored specifically to the member firm’s

business and addresses the activities of all its associated persons. This Notice

highlights particular instances where heightened supervision of an associated

person may be appropriate. Firms are encouraged to adopt the practices that

are outlined in this Notice to strengthen their own supervisory procedures, as

appropriate to their business.

This Notice is one of several FINRA initiatives focused on associated persons

with a history of past misconduct that pose a risk to investors and the firms

that employ them. These initiatives are designed to strengthen oversight

of such associated persons and firms through a combination of guidance,

rule changes, and FINRA examination and surveillance programs. FINRA

also is simultaneously issuing Regulatory Notice 18-16 seeking comment on

proposed rule amendments to further efforts to protect investors.

Questions concerning this Notice should be directed to Kosha Dalal, Associate

Vice President and Associate General Counsel, Office of General Counsel

(OGC), at (202) 728-6903 or [email protected].

Regulatory Notice 18-15

April 30, 2018

Notice Type



Guidance

Suggested Routing

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Compliance



Legal



Operations

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Registered Representatives



Senior Management

Key Topics

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Heightened Supervision

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Supervision

Referenced Rules & Notices

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FINRA Rule 3110

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Notice to Members 97-19

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Notice to Members 98-38



Regulatory Notice 18-16

Heightened Supervision

Guidance on Implementing Effective Heightened

Supervisory Procedures for Associated Persons With

a History of Past Misconduct

Background & Discussion

FINRA administers comprehensive regulatory programs designed to help our members

maintain trust in the financial markets. These programs serve multiple purposes in

advancing FINRA’s mission of protecting investors and market integrity—including

promoting compliance with applicable rules, creating a level playing field, and enhancing

transparency and access to information. One of their most important purposes is to

protect investors from bad actors: those who seek to evade regulatory requirements and

harm investors for their own personal gain. FINRA continues to evaluate and augment its

regulatory programs to better identify and supervise potential bad actors.

Member firms also have a key role to play in protecting investors from bad actors. While

FINRA believes that the vast majority of registered representatives seek to serve their

clients in accordance with all applicable regulatory requirements, ongoing vigilance by

member firms is critical. Member firms should be reviewing and updating their supervisory

systems and procedures for hiring practices, monitoring brokers and investigating red

flags suggestive of misconduct. FINRA requires member firms to establish and maintain

supervisory systems for each of their associated persons and to test and verify annually

that they have established reasonable procedures, including procedures for heightened

supervision of associated persons, where necessary. FINRA and the SEC have emphasized

the need for heightened supervision when a member firm associates with persons who

have a history of industry or regulatory-related incidents.

These heightened supervisory

procedures are a critical element in a member firm’s supervisory system. As such, it

is essential that firms monitor the histories of their associated persons and establish

heightened measures to supervise the activities of those associated persons with greater

potential of creating customer harm.

FINRA previously issued guidance regarding the application of heightened supervisory

plans for associated persons with a history of industry or regulatory-related incidents.

For example, a firm that hires an associated person with a recent history of customer

complaints, disciplinary actions involving sales practice abuse or other customer harm,

or adverse arbitration decisions should determine whether it needs special supervisory

procedures for that associated person, or whether its existing supervisory procedures are

sufficient to address the circumstances.

Firms also should make this determination where

an associated person, during his or her employment with the firm, develops a history of

problems.

Member firms often serve as the first line of defense against customer harm through

establishing and maintaining effective supervisory systems, particularly with regard to

associated persons who may pose higher risks of causing customer harm. In order to

provide additional guidance to firms, FINRA has identified certain circumstances under

which firms are encouraged to consider implementing heightened supervisory procedures

for an associated person.

Implementation of the suggested recommendations may

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help to reduce future customer harm by brokers; however, the recommendations below

are not intended to be an exhaustive list of circumstances firms should consider when

determining whether to implement heightened supervisory procedures. Moreover, a firm’s

implementation of the recommendations in and of themselves would not necessarily

satisfy its obligations under Rule 3110(a) to establish and maintain a supervisory system

reasonably designed to achieve compliance with applicable securities laws and applicable

FINRA rules or other obligations that may arise under FINRA rules.

Heightened Supervisory Procedures

A firm should routinely evaluate its supervisory procedures to ensure they are appropriately

tailored for each associated person and take into consideration, among other things,

the person’s activities and history of industry and regulatory-related incidents. When an

associated person of the firm has a history of industry or regulatory-related incidents, the

firm must make a reasonable determination as to whether its standard supervisory and

educational programs are adequate to address the issues such person’s history raises or

whether the firm should develop tailored heightened supervisory procedures to address

such issues. The failure to assess the adequacy of its supervisory procedures in light of an

associated person’s history of industry or regulatory-related incidents would be closely

evaluated in determining whether the firm itself should be subject to disciplinary action for

a failure to supervise should that person be the subject of a future industry or regulatory-

related incident.

A. Identifying Individuals for Heightened Supervision

In identifying which associated persons to place on heightened supervision, firms should

consider, among other things, customer-related regulatory actions; criminal matters; the

firm’s pre-registration investigation; internal investigations; firm-imposed discipline;

disciplinary actions; final, pending and settled arbitrations; past, open or settled customer

complaints; terminations for cause; and other items disclosed on the person’s uniform

registration forms.

While final adverse adjudicated matters such as disciplinary actions,

criminal matters and arbitrations clearly indicate a disciplinary problem, a pattern of

unadjudicated matters, such as unadjudicated customer complaints, also may be indicative

of a history that should be carefully reviewed.

In addition, FINRA believes that the following two circumstances raise significant investor

protection concerns, and firms should evaluate the facts and circumstances to make a

determination of whether heightened supervision would be appropriate.

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

Heightened Supervision of Statutorily Disqualified Persons During Eligibility

Review Process

Currently, if an associated person who has an industry or regulatory-related event

that qualifies as a statutory disqualification (SD) under the Securities Exchange Act

of 1934 (Exchange Act) wants to continue associating with a member firm, he or she

must undergo a FINRA eligibility proceeding.

Under FINRA’s current rules, a person

who becomes statutorily disqualified while associated with a member firm is allowed

to remain associated with that member firm during FINRA’s review process, so long

as the member firm promptly files a Form MC-400 application (SD Application). In

reviewing an SD Application, FINRA can seek to prevent the statutorily disqualified

person from associating with a member firm or can permit the statutorily disqualified

person to associate with a member firm if it is consistent with the public interest and

protection of investors. Generally, where FINRA permits the statutorily disqualified

person to associate or continue association with a member firm, FINRA will condition

the association on the establishment of certain safeguards, including the adoption and

implementation of a heightened supervisory plan by the member firm of the person’s

business activities. To further promote investor protection, member firms should

consider adopting and implementing an interim plan of heightened supervision for

any statutorily disqualified person associated with the firm once the SD Application

is filed with FINRA and to keep such heightened supervisory plan in place while the

review is pending. FINRA believes heightened supervision may be appropriate for such

persons because they have already been statutorily disqualified, and, in nearly every

case, the continued association of a statutorily disqualified person approved through a

FINRA eligibility proceeding is conditioned on the individual being subject to a robust

heightened supervision plan.



Heightened Supervision of Persons While Disciplinary Case Is On Appeal

Currently, when an associated person or member firm in a litigated disciplinary case

appeals a Hearing Panel decision to the National Adjudicatory Council (NAC), sanctions

are generally stayed pending an appeal.

In cases where the Hearing Panel has rendered

a decision making a finding of violation against the associated person and where an

appeal is filed, to further promote investor protection, firms should consider adopting

and implementing an interim plan of heightened supervision for such associated

person and keep such heightened supervisory plan in place while the appeal is pending.

FINRA believes heightened supervision may be appropriate for such persons because

they have already been found to have violated a rule.

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B. Developing and Implementing a Heightened Supervision Plan

Once a firm determines that heightened supervision is necessary, the firm should develop

written, tailored heightened supervisory procedures designed to address the nature of

the particular concerns the associated person’s incident history raises and the nature of

such person’s ongoing activities. When developing a heightened supervision plan, the firm

should determine the parameters of the plan on a case-by-case basis for each associated

person that the firm has identified as requiring heightened supervision.

In making this determination, a firm should consider whether the nature of the concerns

the associated person’s incident history raises involved a particular product, customer type

or activity. In any of these instances, the firm should examine the product, customer type

or activity to identify the level and type of risk it presents. The firm should then determine

what type of supervision might best control and limit this type of risk. The plan should

reflect a firm’s reasonable consideration of how to effectively supervise the individual

through tailored provisions designed to prevent and deter future incidents.

FINRA has provided a number of factors that firms should consider including in a

heightened supervision plan. Firms are cautioned that these factors are neither exhaustive

nor will they constitute a safe harbor for FINRA rules. Based on staff experience, FINRA

believes effective heightened supervision plans should include, at a minimum:

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designating a principal with the appropriate training and experience to implement

and enforce the plan;

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requiring appropriate additional training for the associated person subject to the

plan to address the nature of incidents resulting in the plan;

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requiring the written acknowledgment of the heightened supervisory plan by the

associated person subject to the plan and the designated supervisory principal; and

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periodically reviewing the heightened supervision plan to assess its effectiveness.

In addition to these minimum provisions, FINRA has seen, among other things, effective

heightened supervision plans that provide for:

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heightened supervision of the associated person’s business activities, including

customer-related activities, employee personal trading accounts, outside business

activities and private securities transactions;

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proximity of the supervisor to the associated person;

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more frequent contact between the supervisor and the associated person;

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more frequent review of the associated person’s communications, particularly with

customers;

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more frequent monitoring or inspection of the associated person’s office(s); and



expediting the handling of customer complaints related to the associated person.

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Endnotes

1. See Regulatory Notice 18-16 (FINRA Requests

Comment on FINRA Rule Amendments Relating

to High-Risk Brokers and the Firms that Employ

Them) (April 2018). In connection with our

on-going efforts to address high-risk brokers,

FINRA also will be publishing revised Sanction

Guidelines shortly.

2. See, e.g., Dep’t of Enforcement v. J. Alexander

Sec., Inc., No. CAF010021, 2004 NASD Discip.

LEXIS 16, at *51 (NAC Aug. 16, 2004), aff’d sub

nom. Robert J. Prager, Exchange Act Rel. No.

51974, 2005 SEC LEXIS 1558 (July 6, 2005); Signal

Sec., Inc., Exchange Act Rel. No. 43350, 2000

SEC LEXIS 2030, at *17 (Sept. 26, 2000); James

Harvey Thornton, 53 S.E.C. 1210, 1216 (1999);

Consolidated Inv. Serv., Inc., 52 S.E.C. 582, 588-89

(1996); Notice to Members 97-19 (April 1997);

Notice to Members 98-39 (May 1998).

3. See Notice to Members 97-19 (stating that a

member firm with a registered representative

who develops a history of customer complaints,

final disciplinary actions involving sales practice

abuse or other customer harm, or adverse

arbitration decisions should consider developing

special supervisory procedures for that registered

representative); and Notice to Members 98-39

(indicating that unexpected supervisory visits

to offices with personnel who have disciplinary

records may be appropriate). See also, Robert W.

Cook, President and CEO, FINRA, Address at the

McDonough School of Business, Georgetown

University: Protecting Investors From Bad

Actors (June 12, 2017), available at www.finra.

org/newsroom/speeches/061217-protecting-

investors-bad-actors; and FINRA 2018 Regulatory

and Examination Priorities Letter (January 8,

2018), available at www.finra.org/industry/2018-

regulatory-and-examination-priorities-letter.

A member firm’s supervisory system is critical to protecting investors and market

integrity, particularly where persons associated with the firm have a history of industry or

regulatory-related incidents. It is essential that firms monitor the regulatory histories of

their associated persons and establish additional measures to supervise the activities of

those individuals with greater potential of creating customer harm. The implementation

of heightened supervision does not diminish the importance of a member firm’s overall

supervisory obligations. Member firms must continue to have supervisory systems

reasonably designed to ensure compliance with applicable securities laws and FINRA

rules for each type of business conducted by the firm and its associated persons.

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easily understandable. However, please be aware that, in case of any misunderstanding, the rule language prevails.

4. See FINRA Rule 3110(e), which requires a

firm to ascertain by investigation the good

character, business reputation, qualifications

and experience of an applicant before it registers

that applicant with FINRA. Firms are advised to

consider all available information gathered in

the pre-registration process for this purpose,

including Form U4 and U5 responses, searches

of the CRD system, fingerprint results, private

background checks and communications

with previous employers. In addition, FINRA

strengthened the background check obligations

of firms by requiring firms to adopt written

procedures reasonably designed to verify the

accuracy of completeness of the information

contained in the applicant’s Form U4. See also

Notice to Members 97-19.

5. FINRA also requires heightened supervision

in some cases when a firm hires numerous

individuals from a disciplined firm. In such

cases, a firm can become a “taping firm,” and

be required to tape record all of its registered

persons’ phone calls with investors. See FINRA

Rule 3170 (Tape Recording of Registered Person

by Certain Firms).

6. See the Uniform Application for Securities

Industry Registration or Transfer (Form U4),

the Uniform Termination Notice for Securities

Industry Registration (Form U5) and the Uniform

Disciplinary Action Reporting Form (Form U6).

7. See Regulatory Notice 18-16 (April 2018), in which

FINRA is seeking, among other things, comment

on proposals to require mandatory heightened

supervision in the two instances described.

8. Events triggering statutory disqualification

include, for example, certain enumerated

misdemeanor and all felony criminal

convictions for a period of ten years from the

date of conviction; temporary and permanent

injunctions (regardless of their age) involving a

broad range of unlawful investment activities;

bars (and current suspensions) ordered by the

SEC or a self-regulatory organization (SRO); and

findings that a person willfully has made or

caused to be made false statements of a material

fact to an SRO. See Sections 3(a)(39) and 15(b)(4)

(A) of the Exchange Act; FINRA By-Laws Article III,

Section 4. Persons who are or become subject to

a statutory disqualification may seek to enter, re-

enter, or in the case of incumbents, continue in

the securities industry.

9. See FINRA Rule 9311(b).

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