By Anne Sherry, J.D.
NASAA is asking the SEC to reject two proposed FINRA rule changes involving how firms carry out their supervisory responsibilities. One proposal would adopt a three-year pilot program to allow FINRA members to conduct inspections of branch offices remotely, while the other would treat a private residence at which supervisory activities are conducted as a non-branch location. NASAA said that while FINRA premises the proposals on its assertion that technology has advanced far enough to replace in-person supervision, it has failed to support this premise with evidence.
The comment letter asserts that the proposals, taken together, would “alter the basic nature of firm supervision” based on a largely unsupported assertion that inspections can be replaced with unspecified technological alternatives. The state regulators disagree with this approach, writing that meaningful in-person inspections are essential to firm supervision. Contrary to FINRA’s assertions, NASAA says that recent investigations and enforcement actions demonstrate how firm personnel, including supervisors, have used new technologies to evade their regulatory responsibilities and engage in misconduct.
According to NASAA, the FINRA proposals afford too much weight to industry, with too little consideration of the impact on investors. Instead of allowing the rule proposals, the SEC should give FINRA a one year extension of temporary relief to continue to allow staff to work from home. In that time, the Commission should urge FINRA to conduct an examination sweep, issue a public report, and engage in a full rulemaking process for any subsequent proposals.
The proposal process. NASAA believes that the proposals were rushed by being made directly to the SEC with only a 21-day comment period on each. In both cases, FINRA declined to consent to extensions of time, thus precluding stakeholder engagement and depriving the SEC of insights that would have been generated in a full notice-and-comment process. NASAA submits that the FINRA board approved the proposals no later than March 2022, yet they were not filed until July/August—less than 120 days before the temporary relief is set to expire. This “injected unnecessary urgency into the Proposals,” the group writes.
Insufficient record. Furthermore, the state regulators believe that FINRA has not developed a sufficient record to support the proposals. Even though most of its member firms have been operating remotely for more than two and a half years and have data regarding their remote inspection practices, FINRA states that the pilot program is necessary to gather the data to support the proposals. NASAA also wrote that it was never provided data that it requested from SIFMA, casting doubt on how statistically rigorous SIFMA’s forthcoming survey is or whether it could be made useful before FINRA seeks to have its proposals adopted. Similarly, NASAA held discussions with FINRA staff as early as October 2021, regarding a survey FINRA was purportedly drafting; to NASAA’s knowledge, no survey was ever conducted.
Unsupported assumptions. The proposals’ bare statements about the advancement of technology are insufficient to support the proposals, NASAA writes. FINRA does not describe with specificity the technologies being used to conduct effective remote surveillance or provide data about the degree to which these technologies are actually being used by member firms. Instead, FINRA provides anecdotal references about what “firms have indicated” about their uses of technology. Beyond references to obvious technologies like Zoom, FINRA does not identify recent advances in technology that materially improve firms’ ability to perform remote inspections. Importantly, the proposals do not account for the likelihood that some associated persons will actively work to avoid surveillance. Recent enforcement actions and investigations, along with firms’ perennial failures to use technological controls effectively, show that technology cannot guarantee compliance, NASAA asserts.
Specific comments. With regard to the pilot program proposal specifically, NASAA believes that FINRA’s proposed controls are insufficient to effectively monitor firms, allowing principles-based rather than prescriptive details as to how rigorous firms’ policies and procedures must be. The state regulators also believe that a meaningful portion of inspections must occur in person in order to catch misconduct that evades detection by technological means. “If lax remote inspection practices become the norm,” the group cautions, “it will take years of examinations and enforcement actions to bring them back up to an acceptable level.” In NASAA’s view, the pilot program would force regulators to fill the gaps created by lax inspection practices.
As for the supervisory location proposal, NASAA said that FINRA has not explained why inspections of supervisory offices should be reduced. NASAA sees no correlation between technological advances and effective compliance; if anything, supervisory functions are becoming more critical and more challenging as supervisors have less direct contact with supervised persons. The group allows that once a record of effective remote supervision has been established, FINRA could seek approval of the proposal, with three changes to clarify the correspondence and communications subject to firm supervision; require documents to be created and maintained on firm systems; and bring state investigations within the scope of reasons to make a residential location ineligible.