BD Law Blog - by Georgia Securities Lawyer Joel Beck

New FINRA Outside Business Activities Rule in Effect - Part II (Supervision)

In my last post, I covered the adoption of FINRA Rule 3270 as the SRO's new rule on outside business activities, replacing the former NASD Rule 3030 and NYSE Rule 346.  I addressed the new features of the rule, and discussed a broker's role regarding disclosure of outside business activities.  But what about the broker-dealer firm itself - what responsibilities does it have?  Let's take a look.

New FINRA Outside Business Activities Rule in Effect - Part I

On December 15, 2010, FINRA rule 3270 became effective.  The Rule, entitled "Outside Business Activities of Registered Persons" replaces the former NASD Rule 3030 and NYSE Rule 346.  As before, under NASD 3030, the Rule only applies to registered persons, so persons who are only associated with a member are not required to give notice of outside activities under the Rule - though a wise firm would  certainly consider requiring such notice in its written supervisory procedures or compliance manual anyway.

The FINRA rule is much more specific that its NASD predecessor, in that it specifically identifies what might be considered to be an outside business activity and goes far beyond the former instruction to disclose employment or compensation.  Under 3270, a registered person must now disclose, with prior written notice to the firm, whenever he or she is to be, "an employee, independent contractor, sole proprietor, officer, director or partner of another person, or be compensated, or have the reasonable expectation of compensation, from any other person as a result of any business activity outside the scope of the relationship with his or her member firm..."  As with old 3030, those transactions covered under NASD Rule 3040 (the private securities transaction rule) are exempted from this Rule.  The Rule, in the supplementary material (which is still adopted as a rule, so don't be fooled into thinking it is only guidance) also sets forth certain supervisory requirements of the member firm.

So, what does this mean for a broker?  How does the responsibilities of a registered representative change with the adoption of the Rule?  Initially, a broker should notice the timeline for the reporting obligation.  Under Rule 3030, only "prompt written notice" was needed, and it could be argued that prompt notice could have been provided after the outside activity commenced.  Now, under 3270, a broker has an obligation to provide prior written notice, in the form as required by the firm.     

Second, a broker should pay careful attention to the broad reporting requirements under 3270. The old 3030 had limited reporting obligations tied to receipt of compensation or employment.  Now, under 3270, those non-employee roles such as an owner, proprietor, director, etc. now require prior written disclosure.  And, situations where no compensation is earned, but where there might be a reasonable expectation of compensation is now covered.  In short, the new rule is much more expansive that the old, we can likely expect the regulatory staff to be very rigid and harsh in their application and interpretation of the rule.  

Wise brokers will likely want to err on the side of caution and provide disclosures of all outside activities to ensure that they do not run afoul of the new rule, at least until we have a body of cases on the rule that interpret it's meaning.  Firms, too, have much more responsibility under the new rule when it comes to supervising such disclosures and documenting the same.  I'll briefly address those responsibilities in the next post.  

Selling Away Cases Are On the Upswing

... is the headline for an article by Dan Jamison this month over at InvestmentNews.com.  As Dan correctly notes, these cases continue to be an area of regulatory scrutiny.  All the regulators pay close attention to the outside business activities of brokers, especially those brokers at the independent-model broker-dealers.  And Jim Shorris, FINRA's head of enforcement, tells Dan that we will see more of these cases as well. 

But, it is important for firms to recognize that this is not simple an issue for brokers.  If a firm fails to supervise reasonably, the firm can find itself sanctioned as well.  Firms that approve outside securities sales, but fail to record them on its books and records and supervise them, do so in violation of FINRA rules.  And firms that fail to respond to red flags of a broker's outside activities can also find themselves in hot water.

Forewarned is forearmed.  Brokers and firms would be well counseled to closely monitor compliance in this area. 

SEC Charges Blustein In Edward May Ponzi Scheme

Thanks to my friend and fellow securities lawyer Mark Astarita in New York for highlighting a recent SEC against against a former broker and investment advisor.  And, if you're not following Mark's blog, you should.  He's a pioneer in this area, and authored the first blog I recall seeing on regulatory matters. 

The SEC announced earlier this week that it filed civil charges against former broker and investment adviser Frank Bluestein in connection with the Edward May ponzi scheme.  According to the SEC's press release, Bluestein was the largest seller of the ponzi scheme, raising about $74 Million from over 800 investors.  The SEC alleges that Bluestein targeted elderly and/or retired folks to purchase the "investment" and recommended that some of them refinance their homes to gain access to funds to make an investment.  The Complaint alleges that Bluestein pitched these investments as safe and guaranteed, when they were not. The SEC's Complaint can be found here.

In its action, the SEC also asserts that Bluestein misrepresented the due diligence he completed on this product and that he failed to do any meaningful due diligence, even when faced with red flags about the investment. 

I agree with Mark that it appears that the regulators are upping the ante on the due diligence issues and that this area is becoming a focus area in investigations and examinations, as well as in arbitration cases.  Firms and brokers should review their due diligence obligations under the various rules and regulations governing the industry, and make sure that their due diligence is being performed adequately and completely, or be prepared to face the consequences.  

Common Mistakes Stockbrokers Make, Part III - Undisclosed Outside Business Activities

As avid readers of BDLawBlog.com know, I'm posting a series on some of the violations that are most repeatedly found by the regulators, for which brokers are sanctioned.  Continuing this series of mistakes to avoid, today's topic is participating in undisclosed outside business activities.  Look through any monthly report of disciplinary actions, and you'll likely find several brokers who have been disciplined for not disclosed their involvement in an outside business activity.  Sanctions may typically  include a suspension, fine, and censure. 

FINRA Rule 3030 is the outside business activity rule.  It says:  "No person associated with a member in any registered capacity shall be employed by, or accept compensation from, any other person as a result of any business activity, other than a passive investment, outside the scope of his relationship with his employer firm, unless he has provided prompt written notice to the member. Such notice shall be in the form required by the member. Activities subject to the requirements of Rule 3040 shall be exempted from this requirement."

The Rule does not prohibit engaging in outside business activities.  The Rule requires that  brokers  provide their firms with written notice that they are involved in an outside business activity.  But what is an outside business activity?  It's easy to identify those when you are employed by another person or company such as at a retail store, restaurant, or some similar part-time job.  Many brokers, however, fail to recognize the existence of an outside business activity when they receive finder's fees, do consulting work on the side, prepare tax returns for clients for a fee, sell a product that's not a security or do something similar for money.  Under the rule, if you receive money for doing something away from your firm, its likely an outside business activity that requires disclosure.

But it may be a reportable activity even if you don't receive compensation.  Note that the rule defines an outside activity as being "employed."  If you start a new side business but have yet to pay yourself, that may result in you being considered as an employee of that business.  Even serving on the board of directors of a company, depending on the nature of the company, may result in your being considered as engaged in an outside business activity as one Hearing Officer noted in a Default Decision.

Also note that the Form U-4 requires brokers to disclose outside business activities in which they engage, along with additional information about that activity.

Finally, in addition to the regulatory requirements, most firms also have internal policies and procedures relating to Rule 3030.  Most firms will require the broker to obtain approval from the firm before participating in any activity.  Failing to follow the firm's policies and procedures may subject the broker to disciplinary action by the term, including termination.  

The Right Questions

During this time of year, many firms are working on wrapping up their annual compliance programs with respect to their registered reps. by conducting annual compliance meetings, meeting with the brokers, and having the brokers complete written compliance questionnaires.  Unfortunately, some firms fail to ask the right questions at this time, and don't get the information that they want and need to fully assess their risks and identify compliance problems.

What are the right questions?  Put simply, they are questions that are designed to elicit detail about the brokers' activities beyond a simple yes or no.  And, they are questions that are broad, as opposed to narrowly tailored.  For example, some bad questions might be:  "During the past year, did you participate in any private securities transactions?" and "During the past year, did you have any outside employment?"   What's wrong with these question:  1) it assumes that the broker and the firm have the same definition and understanding of what a private securities transaction is or what outside employment is, 2) it doesn't seek to get the information that the compliance department wants. 

What do reps. almost always say when they have sold away?  Its usually along the lines of "I didn't know it was a security.  I was told it was not a security and I did not have to be licensed to sell it."  And with regards to outside employment we often hear: "I wasn't an employee, I was an independent contractor," or "I didn't get commissions, I got a finder's fee." 

As you put together your questionnaire, make sure you're asking questions designed to elicit the information you need to evaluate problems and risks, and to ensure that brokers are aware of what is and is not prohibited by the firm.  Importantly, also remember that following up on these responses is critical to an effective compliance program.

Webcast on Outside Business Activities and Private Securities Transactions

FINRA launched a new webcast this week on understanding the outside business activities rule and private securities transaction rule (NASD Rules 3030 and 3040, respectively).  The 11-minute webcast does a good job explaining the requirements of the Rules, and would be a good, quick lesson for brokers and those who want to better understand these important Rules.  Importantly, the webcast stresses the need for brokers to ensure they understand their firm's policies and procedures in these areas, noting that a firm may impose additional requirements.  Check out the webcast here.

Firms Have to Supervise For Outside Business Activities

Following up the postings on selling away, let's touch on the outside business activity rule.  FINRA (Formerly NASD) Rule 3030 requires associated persons, who are registered, to provide written notice to their firm of any outside business activities in which they are employed, or receive compensation.  The "employment" requirement is interpreted broadly.  The notice is to be given in the manner set forth by the firm.  (See our earlier posting on U-4 requirements, because the U-4 also has a requirement to disclose, in further detail, the outside activities).  Once the broker provides the notice, he or she has complied with the Rule.

Smart firms have more detailed policies requiring approval of outside activities, and require that if the activity is not approved, the broker not participate.  But, if the firm approves it, the firm should continue to monitor the activities through reasonable supervision.  A recent administrative action by the SEC demonstrates the consequences of failing to do so.

Earlier this month, the SEC announced an action against Commonwealth Equity Services, LLP, making findings that the firm failed to supervise reasonably a broker who defrauded about 34 investors, and misappropriated more than $12 Million.  According to the release, the SEC found that the broker had lied to customers about purchases and sells of securities, misappropriated funds, and provided false statements to the customers.     The broker later pled guilty to criminal charges, and, according to the release, was sentenced to 11+ years.

The fraud apparently stemmed from the broker's outside business activities, that included two investment advisory businesses, and a radio station.  The broker had disclosed the activities to the firm, and even provided financial statements for one of his businesses to the firm.  The firm failed to review these, and apparently ignored "red flags" such as evidence the business was failing and the broker was making large capital contributions to keep it running.  Further, the SEC found that the broker failed to disclose his source of funding for the radio station venture on his outside activity form, and the firm failed to follow up.  The SEC asserted that the funding for these activities came from the misappropriated funds.  Finally, the SEC noted that the firm did not have procedures in place to review incoming mail, and that the broker received checks and correspondence from customers, apparently for his outside activities, the mirrored amounts withdrawn from the customers' brokerage accounts.  As a result of the SEC action, the firm was fined $250,000.  (See Release No. 34-56362).

Selling Away - Info for Brokers

Last time we spoke about pointers for firms dealing with selling away.  Today, let's look at the issue from the broker's perspective.  Selling away, technically termed participating in "private securities transactions" is governed by FINRA Rule 3040.  See the Rule here.  As I noted earlier, this Rule applies to all associated persons of a broker-dealer, not just registered folks.  But, it is the registered folks who typically get caught up in this problem, in my experience.

Brokers should read the rule carefully and understand two of its main components.  First, the Rule prohibits associated persons from "participat[ing] in any manner" in a private securities transaction without complying with the Rule.  But what does that mean?  It means what it says - you can't participate in any manner - meaning you can't effect the sale, you can't simply pass on documents to a potential investor, you can't function as a middleman, etc.  So, if you're going to participate, you have to give your firm prior written notice.

The second important area is that if you are going to be compensated in any fashion, you have to receive written approval for the transaction from your firm.  (See my earlier post for the requirements that a firm has to follow if they approve the transaction.)  Compensation includes commissions, finder's fees, compensation for making a referral, etc.  It is interpreted fairly broadly. 

Often, brokers get conned into violating the Rule.  They are presented with a product that they are convinced may be beneficial to their customers, offering a better return than what the market is currently bearing out.  The issuer or distributor of the product may advise the broker that the product is not a security, or that no license is necessary to sell it.  And the broker foolishly believes it and goes along.   Then, along comes the regulators and plaintiff attorneys charging the broker with selling away, making unsuitable recommendations, selling unregistered securities, and more.

Take a quick look at SEC and FINRA disciplinary actions and you'll find numerous instances of brokers paying the consequences for selling away.  Review arbitration awards and you'll see that the broker and his or her firm pays those consequences too, as a result of the principal/agent relationship.  As a broker, be aware that no one else is responsible for your compliance, and consider whether your ability to work in the industry is too valuable to sell away.

A Firm's Obligations Regarding Selling Away

I've been surprised from time to time at the response of some firms to selling away issues presented by their representatives.  It seems that some firms don't understand the regulatory and civil liability that can attach when they fail to supervise in this area.  So, I thought this might be a topic for a good post.

Selling away, also known as participating in private securities transactions, is governed by FINRA (formerly NASD) Rule 3040.  This rue applies to any person associated with a member, not just registered people ( as opposed to the outside business activity rule (Rule 3030) that is limited to folks who are registered with a broker-dealer).  The rule requires that prior to participating in any manner in a private securities transaction, the associated person must provide written notice to his or her firm detailing the transaction, that person's role in it, and disclose whether he or she will or may receive any compensation. 

At that point, the broker-dealer's obligations increase.  The firm must then provide the associated person with written notice indicating whether the activity is approved or disapproved.  Importantly, if the firm approves a transaction for which the associated person will be compensated, the firm must record the transaction on its own books and records and supervise it as if it were executed on behalf of the firm. 

Did you get that?  A firm cannot approve a transaction by an associated person, for compensation, and then wash its hands of it.  Once approved, the firm has an obligation to supervise, and the transaction is no longer really "selling away" but it becomes a transaction of the firm, giving an additional area for regulators and plaintiff's lawyers to hone in on, particularly when the transactions are unsuitable for the clients, or when the associated persons misrepresent or make material omissions about the security.