FINRA recently released a proposal that would change the relationship between brokerage firms and their registered representatives who do work for unaffiliated registered investment advisors. The new rule “is intended to reduce unnecessary burdens while strengthening investor protections relating to outside activities.”
Currently, FINRA Rule 3270 and FINRA Rule 3280 govern business activities of registered representatives outside of their associated members. Rule 3270, governing outside business activities of registered persons, provides that before a registered representative can engage in an outside business activity (activity outside the scope of the person’s relationship with the member firm) he is to provide written notice to his member firm. Where an outside business activity is a private security transaction, the registered representative is required to notify the associated member. From there the associated member can approve or disapprove the transaction. If approved, the associated member shall record the transaction on its books and supervise the transaction. If disapproved, the registered representative is not to participate, in any manner whether directly or indirectly, in the transaction.
This proposal follows FINRA’s recent review of the rules governing outside business activities of registered persons (Rule 3270) and private securities transactions of associated persons (Rule 3280). The new rule is tentatively titled “Outside Business Activities” (Rule 3290) and sets forth the following framework for outside related activities.
First, registered persons are not permitted to participate in business activities outside the scope of the relationship with the person’s member firm without prior written notice to the member. Where the activity is investment-related, the registered person is required to receive written approval from the member. The rule states that notification is to be in a form specified by the member and must describe (1) the proposed activity and (2) the person’s proposed role. The member may disapprove the activity or place limitations on the activity.
Second, the proposal provides guidance on a member’s obligations upon notification of an investment-related activity. This guidance contains three parts. The member is required to “perform a reasonable assessment of the risks” of the proposed activity. The rule doesn’t fully define the contours of the “reasonable assessment” but it does state that the reasonable assessment is required to evaluate whether the proposed activity will:
- interfere with or otherwise compromise the registered person’s responsibilities to the member’s customers; or
- be viewed by customers or the public as part of the member’s business based upon, among other factors, the nature of the proposed activity and the manner in which it will be offered.”
The member is also required to consider whether the activity would require the person’s registration as a broker or dealer under the Exchange Act if not for the person’s association with a member. Last, the member is required to “make a reasonable determination” as to approval, disapproval, or approval with specific limitations of conditions of the proposed activity.
When complete, the member then advises the registered individual as to approval, disapproval, or approval with conditions or limitations. Where the member decides to impose conditions or limitations on its approval, the member has a responsibility to “reasonably supervise” the registered person. Such supervision is limited to the registered person’s compliance with the imposed conditions and limitations.
If the approved activity would require registration as a broker or dealer under the Exchange Act, but for the person’s association with a member and the person is not registered, the activity shall be deemed to be that of the member. In such a case, the member is subject to all applicable securities laws, regulations, and FINRA rules. The rule specifically references that this includes any such requirements pertaining to supervision and record-keeping. Where the person is associated with more than one member, the members may develop a “detailed, allocation arrangement.” Notably, the rule used the permissive modal verb “may” rather than the mandatory modal verb “must” meaning it is not required for members to agree on an allocation of responsibility of monitoring compliance with the securities laws, regulations, and FINRA rules.
Lastly, members are required to keep records demonstrating its compliance with the rules set forth in the proposal. Such records are to be preserved for at least three years following the registered person’s employment or association with the member.
The proposal significantly changes the landscape for a member’s involvement in a registered representative’s investment advisory activities. Under the previous rules, a member had a responsibility to supervise the private security transaction as if the transaction were executed on the member’s behalf. The proposed rule changes this function to require a supervisory obligation in two situations.
First, if the member imposes conditions or limitations on a registered person’s participation, it would be required to reasonably supervise the registered person’s compliance with those conditions or limitations. For example, a member could approve the registered representative’s actions with a third party investment advisory business on the condition of limiting the types of investments in client advisory accounts. In such a scenario, the member’s supervisory responsibility would be limited to assuring compliance with the member’s internal limitation as to the permissible investment types in client accounts. The member would have no supervisory responsibility as to record-keeping, suitability, etc…
Second, if the registered person could only engage in the outside business activity but for the person’s association with a member, i.e. the activity would require registration as a broker or dealer under the Exchange Act, the member must treat the activity as its own and comply with all laws and regulations.
In sum, the new proposal clarifies the duties and obligations of member firms in regards to their associated person’s outside activities, especially as those activities relate to advisory services. Public comments concerning the new rule can be found at http://www.finra.org/industry/notices/18-08
Winget, Spadafora & Schwartzberg, LLP is closely monitoring this development. If you would like to discuss the implications of the proposed rule change or would like compliance guidance, please do not hesitate to contact any of the firm’s securities practice group leaders set forth below.