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Get Cultured: FINRA’s 2016 Examination Priorities

January 12, 2016

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In its 2016 Regulatory and Examination Priorities Letter released in January, the Financial Industry Regulatory Authority (FINRA) addresses the issues of culture, conflicts of interest and ethics, risk management and controls, and liquidity.  FINRA’s emphasis on scrutinizing firm culture is a top priority, despite concerns that it amounts to micromanagement of a subjective concept. FINRA noted that it would assess five indicators of firm culture: “whether control functions are valued within the organization; whether policy or control breaches are tolerated; whether the organization proactively seeks to identify risk and compliance events; whether supervisors are effective role models of firm culture; and whether sub-cultures that may not conform to overall corporate culture are identified and addressed.”

FINRA subsequently issued a sweep letter to Members, noting its intent to review “how firms establish, communicate and implement cultural values, and whether cultural values are guiding business conduct.” As part of this review, FINRA plans to meet with executive business, compliance, legal, and risk management staff of Member firms in order to discuss their cultural values. In preparation for these meetings, FINRA has requested information concerning the following by March 21, 2016:

  1. Key policies and processes by which the firm establishes cultural values;
  2. Descriptions of the processes employed in establishing, communicating and implementing a firm’s cultural values;
  3. Descriptions of how firms assess and measure the impact of cultural values;
  4. Summaries of the processes firms use to identify policy breaches in determining whether a breach of its cultural values has occurred;
  5. Descriptions of how firms address cultural value policy or process breaches once discovered;
  6. Descriptions of firms’ policies and processes to identify and address firm subcultures that may depart from the cultural values articulated by senior management;
  7. Compensation practices and how they reinforce a firm’s cultural values; and
  8. Descriptions of the cultural value criteria used to determine promotions and compensation.

The issues surrounding FINRA’s prioritization of assessing firm culture is rooted in concerns of fraud and breach of the fiduciary duties owed to investors, however difficult an assessment of firm culture may be.

Interestingly, a recent paper by business school professors at the University of Chicago and University of Minnesota highlights the relevance of firm culture in the first large-scale study to document the economy-wide context of misconduct among financial advisers and advisory firms.[1] It found that about 7% of financial advisers have misconduct records, and at some of the leading financial firms in the country, more than 15% of financial advisers have misconduct records. Out of those financial advisers who had been fired for misconduct, 44% were reemployed in the financial services industry within a year. “The substantial presence of repeat offenders implies that the industry does not immediately purge advisers who have engaged in misconduct”.[2] The paper posits that there is a “match on misconduct”, whereby those advisers who lose their jobs following misconduct simply move on to firms that are more tolerant of, and engage in more misconduct.[3] Although individual firms may be strict in terminating the employment of advisers found to have engaged in misconduct, the financial industry was found to be “substantially less strict than firms individually,” and that “The reallocation of financial advisers to new firms partially blunts the firm-level response to misconduct,”[4] an occurrence which frustrates the financial industry’s disciplining mechanism, decreasing the punishment for misconduct.[5]

The study found that misconduct is more common among firms that advise retail investors, and in wealthy, elderly, and less educated counties, suggesting that misconduct is targeted at customers with potentially less financial sophistication.[6]

The authors suggest that an increase in market transparency and policies helping unsophisticated consumers access more information is a natural policy response to decreasing instances of misconduct. Will FINRA’s scrutiny on firm culture assist in this goal, or does it go too far in its micromanagement?

 

[1] Egan, Mark and Matvos, Gregor and Seru, Amit, ‘The Market for Financial Adviser Misconduct’ (March 1, 2016). Available at SSRN: http://ssrn.com/abstract=2739170

[2] Ibid, 14

[3] Ibid, 21

[4] Ibid, 18

[5] Ibid, 26

[6] Ibid, 26-27