FINRA Seeks Comments on Proposed New Rule to Govern Outside Business Activities and Private Securities Activities of FINRA Member Associated Persons

If adopted, proposed new FINRA Rule 3290 will be significant for broker-dealers who allow their associated persons to engage in outside business activities (in particular in securities related fields – such as serving with/as a third-party investment adviser) and broker-dealer staff who engage in such activities.  In general, the changes may make the lives of both such groups a bit easier.

FINRA Rule 3290 would be a replacement for both current FINRA Rule 3270 (Outside Business Activities (OBA) of Registered Persons) and current FINRA Rule 3280 (Private Securities Transactions of an Associated Person) for its member broker-dealers.  As explained in Regulatory Notice 18-08, compliance with proposed FINRA Rule 3290 would involve only modest and mostly clarifying changes for most traditional “3270” activities.  The impact on what are now “3280” activities could be more pronounced.

Probably of the greatest interest for many broker-dealers: proposed Rule 3290 would ease current requirements with respect to the investment advisory activities of their registered persons.  Under Rule 3280, FINRA members must supervise and record on the members’ books and records the transactions resulting from a variety of outside “IA” activities of their associated persons. Under proposed Rule 3290, any IA activity conducted on behalf of a dually registered “BD/IA” or for an IA affiliate of a member would be excluded from the rule.  Any IA activity conducted for a third-party, non-affiliated IA would constitute an “investment-related” activity under the rule – as a result, it would require that the registered person provide prior written notice of such activity, and the FINRA member would then be required to conduct a risk assessment and based on its assessment, to: (a) approve the registered person’s participation, (b) approve it subject to conditions or limitations, or (c) disapprove it. However, the proposed rule would not impose a general supervisory obligation over the IA activities and would not require the FINRA member to record on its books and records transactions resulting from such IA activities.

Under the proposed rule, if an activity is not “investment related,” the broker-dealer would effectively have no material obligations (other than receiving notice of the activities and recording the activity on the associated person’s Form U-4).  If the activity is “investment-related,” then the broker-dealer would be required to perform a risk assessment.  The proposed rule defines “investment-related” as “pertaining to securities, commodities, banking, insurance, or real estate (including, but not limited to, acting as or being associated with a broker-dealer, issuer, investment company, investment adviser, futures sponsor, bank, or savings association).”

The proposed rule would impose a supervisory obligation in two key situations:

-First, if a broker-dealer decides to impose its own conditions or limitations on a registered person’s participation in an investment-related activity, the broker-dealer would then be required to “reasonably” supervise the registered person’s compliance with those specific conditions or limitations.  Actual supervision of the underlying activities would not be required.

-Second, to the extent that a broker-dealer approves a registered person’s participation in a proposed investment-related activity and such activity would require, “if not for the person’s association with a member, registration as a broker or dealer under the Exchange Act and the person is not so registered,” the activity would be deemed to be part of the broker-dealer’s own business.  So, if an associated person could only legally engage in an “OBA” because the individual is associated with a FINRA member, the FINRA member approving that activity must treat the activity as its own in all respects.  Accordingly, all applicable securities laws and regulations and FINRA rules, including supervision and recordkeeping, would apply to the FINRA member with respect to the approved activity.

Under this second situation, if the registered person is associated with more than one FINRA member, the individual FINRA members would be permitted to develop a formal allocation arrangement whereby at least one member agrees in writing with specificity to comply with all applicable securities laws and regulations and FINRA rules (including supervision and recordkeeping obligations) regarding the proposed activity.

As provided in summary as part of Regulatory Notice 18-08:

Selling Private Placements Away from Member Subject to the proposed rule, potentially to the fullest extent – prior notice by the registered person and risk assessment by the member. If the member disapproves the activity, it has no further obligation. If the member approves the activity, the activity becomes part of the member’s business and must be supervised and recorded as such.
Activities at Third-Party IA Subject to the proposed rule, but in an intermediate manner – prior notice by the registered person and risk assessment by the member because it is investment related and not excluded from the proposed rule, but the member is not required to supervise or keep records of the IA activities.
Non-Investment Related Work (e.g., car service, seasonal retail) Subject to the proposed rule, but in a limited manner – a registered person must provide prior notice to the member, but the member is not required to perform a risk assessment of or supervise the activity.
Activities at Affiliates (e.g., IA, Insurance and Banking Affiliates) Generally excluded from the proposed rule – the proposed rule excludes activities at affiliates, whether or not investment related, unless those activities would require registration as a broker or dealer if not for the person’s association with a member.
Personal Investments (e.g., Buying Away) Excluded from the proposed rule, but potentially subject to other rules (e.g., FINRA Rule 3210) or firm-imposed notice requirements.

 

Guidance to Prevent Non-Line Supervisory Liability

In light of the supervisory standards applicable to compliance officers and in-house attorneys with broker-dealer and investment management firms, these individuals and firms need to appreciate and manage the risks of supervisory liability being applied to them due to the violative conduct of business personnel.  In an article titled “Compliance and Legal Officer Guidelines To Prevent Non-Line Supervisory Liability” my colleague Carrie DeLange and I analyzed the “Gutfreund Standard” and the SEC’s more recent guidance from a Division of Trading and Markets “FAQ,” and other statutes and rules, and provide guidance for compliance officers and in-house attorneys with broker-dealer and investment management firms to best manage these situations. Continue reading “Guidance to Prevent Non-Line Supervisory Liability”

SEC Announces Share Class Selection Disclosure Initiative

Last week, the SEC announced a “Share Class Selection Disclosure Initiative” being led by the Asset Management Unit of the Division of Enforcement. This initiative warrants close examination for investment advisers who regularly recommend different mutual fund share classes for their clients and by their affiliated broker-dealers. This effort continues the SEC’s focus on 12b-1 fees, and provides the SEC with a vehicle to efficiently bring enforcement actions against those firms who have failed to properly disclose conflicts related to those fees. FINRA has not yet issued any related, formal pronouncements. Until FINRA issues guidance, affiliated broker-dealers concerned with how to handle any 12b-1 fee issues that they may have will need to consider FINRA’s “extraordinary cooperation” guidance. Continue reading “SEC Announces Share Class Selection Disclosure Initiative”

Fiduciary Rule Myths

MYTH:  “Advisors must recommend the best available investment.”

We recently pointed out that under the DOL fiduciary rule, it’s a myth that advisors have to recommend the lowest cost investment. They don’t.

Here’s another myth about investment recommendations that isn’t true: advisors have to recommend the best investment to their customers. Presumably, this comes up because of the Impartial Conduct Standards in the Best Interest Contract Exemption (BICE). One of the requirements in those Standards is that a recommendation be in the best interest of the customer. This best interest requirement may lead some to think that advisors have to meet an essentially impossible standard. As with a lowest-cost recommendation, however, a mandate to recommend the best investment is a myth…it just isn’t true. Even the DOL has said so:

Continue reading “Fiduciary Rule Myths”

SEC’s 2018 Exam Priorities – Worth the Wait

The SEC’s Office of Compliance Inspections and Examinations (OCIE) released its 2018 National Exam Program Examination Priorities on February 7, 2018 (“2018 Priorities Letter”). While issued later than in years past and almost a month to the day after the publication of the priorities letter from the Financial Industry Regulatory Authority (FINRA), OCIE deserves credit for the increased transparency and guidance provided in the 2018 Priorities Letter. By way of perspective, OCIE’s sixth publication of its examination priorities more than doubled the amount of information provided in last year’s edition. This improved transparency is consistent with the public statements of OCIE’s Director. Despite the greater detail, there appears to be one glaring omission: OCIE does not discuss how the anticipated rulemaking by the Commission regarding the development of a fiduciary standard may impact its priorities. However, upon further consideration and recalling that OCIE’s primary mission is to conduct examinations to assess compliance with the current securities laws, we realize it would have been premature for OCIE to discuss views on some yet-to-be formulated SEC fiduciary standard. That said, OCIE is clearly prioritizing the protection of retail investors even more than in years past, which is consistent with the SEC Chairman’s public statements about prioritizing the protection of “Main Street” investors. While the SEC Chairman has made these issues a “Main” priority, the SEC’s heightened focus regarding retail and retirement investors has been strengthening significantly since the Retirement-Targeted Industry Reviews and Examinations (ReTIRE) Initiative announced a few years ago and through the SEC’s announcement this past autumn of the Retail Strategy Task Force. Thus, OCIE leads into the 2018 Priorities Letter in the second and third sentences by opening with: “…we will continue to prioritize our commitment to protect retail investors, including seniors and those saving for retirement. We will especially be looking closely at products and services offered to retail investors, as well as the disclosures they receive about those investments.” This focus is similar to the focuses emphasized by FINRA in its recent priorities letter. Continue reading “SEC’s 2018 Exam Priorities – Worth the Wait”

Reasonable Compensation

In a previous post , we debunked the myth that the Fiduciary Rule requires advisors to recommend the lowest-cost investments. In this post, we discuss what is required when it comes to fees and compensation – that they not exceed a “reasonable” level.

Broker-dealers and advisors who rely on the Best Interest Contract Exemption (BICE) need to comply with the Impartial Conduct Standards. These include three requirements: (1) recommendations to plan and IRA investors must be in the “best interest” of the customer, (2) communications with customers must not include materially misleading statements, and (3) the firm’s and advisor’s compensation must be reasonable. If any of these is not met, they have engaged in a non-exempt prohibited transaction.

The reasonable compensation requirement is more than a condition imposed by the DOL. The requirement is statutory. That is, it is imposed under ERISA for employer-sponsored plans. It is imposed under the Code for all service arrangements with both plans and IRAs. The reasonable compensation limit applies to service providers regardless of whether or not they are fiduciaries.

This means two things. First, the requirement is not going away. Because it is embedded in the statutes, it can only be repealed by Congress – not the DOL, the SEC or any state rule – and this is not likely. While the DOL will undoubtedly make changes to BICE and other exemptions during the current transition period, firms and advisors cannot expect the reasonable compensation requirement to go away, or even be changed. Second, it applies to all service relationships. Even for level-fee advice arrangements – which do not have to satisfy BICE or any other similar exemption, compensation must be reasonable.

Reasonable compensation defined
What does “reasonable” mean? The requirement is that compensation be reasonable in relation to the services and benefits being provided. As the DOL explains in the BICE preamble:

At bottom, the standard simply requires that compensation not be excessive, as measured by the market value of the particular services, rights, and benefits the (advisor) and Financial Institution are delivering to the Retirement Investor.

For compensation to be reasonable, it is not necessary to recommend a product that pays the least compensation. It is not necessary that compensation be below average. It just cannot rise to a level that is excessive in relation to the services and benefits provided.

Note that the reasonableness requirement applies to the compensation received by the broker-dealer and to the amount passed on by the firm to the advisor. If, for example, a firm receives an excessive level of commissions for recommending a product, this would violate the standard even if the advisor’s “share” of the commission were within industry norms.

Value of services
The BICE preamble also makes clear that all services and benefits provided can be taken into account – not just the advice services – in determining if compensation is reasonable. The DOL offers the following example:

In the case of a charge for an annuity or insurance contract that covers both the provision of services and the purchase of the guarantees and financial benefits provided under the contract, it is appropriate to consider the value of the guarantees and benefits in assessing the reasonableness of the arrangement, as well as the value of the services.

In other words, the value of the services may be enhanced by the complexities and services associated with a product, and those can be considered in determining whether the compensation is reasonable.

Factors in determining reasonableness
How is “reasonableness” determined? While the requirement is imposed by law, the standard itself is an industry, or market standard. Per the DOL, there are “several” factors involved. They include, but are not necessarily limited to, the:

  •  market pricing for similar services and products
  •  scope of monitoring, if any
  •  complexity of the product

To help determine market standards for compensation, broker-dealers use benchmarking or similar services. In fact, the DOL has said that firms may want to seek “impartial reviews” of their fee structures. At the same time, firms should recognize that “reasonable” and “customary” do not necessarily mean the same thing. That is, in limited circumstances, the markets may not provide competitive pricing. However, where markets are transparent and competitive, the benchmarking information should properly define reasonable compensation.

Finally, firms may wish to consider “re-benchmarking” their compensation structures at reasonable intervals – what is reasonable this year might not be reasonable next year.

FINRA 2018 Annual Regulatory and Examination Priorities Letter Makes No Mention of a Fiduciary Duty for Brokers

FINRA released its 2018 Annual Regulatory and Examination Priorities Letter (Priorities Letter) on January 8, 2018. While FINRA advises that it can change its priorities in response to circumstances, the purpose of the Priorities Letter is to permit broker-dealers to plan their compliance, supervisory and risk management programs and to prepare for FINRA examinations. Therefore, this Priorities Letter is significant both in what it says and in what it has chosen not to say including failing to discuss FINRA’s views regarding a “fiduciary standard.”
Continue reading “FINRA 2018 Annual Regulatory and Examination Priorities Letter Makes No Mention of a Fiduciary Duty for Brokers”

Fiduciary Rule Myths

MYTH:  “Advisors must recommend the lowest cost investment.”

This post discusses what broker-dealers and their advisors need to do to manage the risks in providing investment recommendations to plans and IRAs. In order to manage those risks, though, broker-dealers and advisors need to understand what the rules require. To do that, we need to debunk some “myths” about the rules. Continue reading “Fiduciary Rule Myths”