FINRA Rep Monitoring Rule Change Could Trigger RIA Compensation Renegotiation

A new proposed rule published by the Financial Industry Regulatory Authority (FINRA) would replace FINRA Rules 3270 and 3280 and is, according to FINRA leadership, intended to reduce unnecessary burdens while strengthening investor protections relating to advisers’ outside business activities.

Advisers and other financial industry practitioners are invited to share comments with FINRA through April 27, 2018. Comments must be submitted through one of the following methods: Emailing comments to pubcom@finra.org; or mailing comments in hard copy to Jennifer Piorko Mitchell, Office of the Corporate Secretary, FINRA, 1735 K Street NW, Washington, DC, 20006-1506.

By way of background, the announcement comes after FINRA launched what is described as “a retrospective review of its outside business activities and private securities transactions rules to assess their effectiveness and efficiency.”

As FINRA explains, these rules serve important goals—they seek to protect the investing public when a member’s registered or associated persons engage in potentially problematic activities that are unknown to the member but could be perceived by the investing public as part of the member’s business. An ancillary benefit, FINRA argues, is that the rules protect the member from resulting reputational and litigation risks.

The retrospective rule review confirmed the continuing importance of rules relating to outside activities, FINRA says, but also indicated that the current rules, as well as related guidance, “could benefit from changes to better align the investor protection goals with the current regulatory landscape and business practices.”

In particular, FINRA received significant feedback on “members’ obligations with respect to the investment advisory activities of their registered persons.” Consistent with a number of recommendations by stakeholders during the retrospective review, FINRA is proposing a single streamlined rule to address the outside business activities of registered persons.

Here’s how FINRA explains the streamlined approach: “The proposed rule would require registered persons to provide their members with prior written notice of a broad range of outside activities, while imposing on members a responsibility to perform a reasonable risk assessment of a narrower set of activities that are investment related, allowing members to focus on outside activities that are most likely to raise investor protection concerns.”

Perhaps the most substantive change, FINRA says, is that the proposed rule also would generally exclude a registered person’s “personal investments,” sometimes referred to as “buying away,” and work performed on behalf of a member’s affiliates. Moreover, the proposed rule would not impose supervisory and recordkeeping obligations for most other outside activities, including investment advisory activities at an unaffiliated third-party investment adviser. At the same time, the proposal would hold a member responsible for approved activities that could not take place but for the registered person’s association with a member.

FINRA provides some examples to explain the spirit and general scope of the new rule as currently envisioned:

• When selling private placements away from the FINRA member, for example, this situation would be subject to the proposed rule, potentially to the fullest extent. In other words, such selling activity would require prior notice by the registered person and a 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.
• When a rep engages in activities at a third-party investment advisory shop, this situation would also be subject to the proposed rule, but in an intermediate manner. In this situation, prior notice by the registered person and risk assessment by the member are required, because the activities here are investment related and not excluded from the proposed rule, but the member is not required to supervise or keep records of the activities.
• When a rep engages in non-investment related work, for example car service or seasonal retail, this situation is also 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.
• When a rep engages in activities at affiliates, for example banking or insurance affiliates of the FINRA member, this situation is generally excluded from the proposed rule. Specifically, 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.
• When a rep engages in personal investing activity, or “buying away,” this is excluded from the proposed rule, but potentially subject to other rules (e.g., FINRA Rule 3210) or firm-imposed notice requirements.

Offering some further analysis and explanation, FINRA officials note that a majority of stakeholders that provided feedback during the retrospective review believed that the scope of activities subject to the outside business activities rule, Rule 3270, should be narrowed.

“On the other hand, a significant minority of stakeholders favored the rule’s current notice requirement to ensure that registered persons report a broad range of outside activities to their employing firms,” FINRA admits. “Moreover, a number of stakeholders believed that notice of private securities transactions under Rule 3280 should not be narrowed. The proposed rule takes a balanced approach that would ensure that members are apprised of their registered persons’ outside activities, while tailoring members’ responsibilities to those activities that are most likely to raise investor protection concerns.”

The explanation continues: “To that end, FINRA is proposing a single rule that would require registered persons to provide their firms with prior written notice for all investment-related or other business activities outside the scope of their relationship with the member. The proposed rule would require that a registered person include in the notice a description of the proposed activity and the registered person’s proposed role therein, and that the registered person update the notice in the event of a material change to the activity. With respect to investment related activities only, a registered person would be required to receive prior written approval from the member before participating in the activity.”

The rule would define “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).” This definition is also used for purposes of the Uniform Application for Securities Industry Registration or Transfer (Form U4) and would better harmonize the Form U4 reporting requirements and the notice obligations under FINRA rules, an issue frequently raised during the retrospective review.

Also important, the concept of “business activity” would be similar to current Rule 3270, with minor clarifying changes, and would be defined in the rule as acting as an employee, independent contractor, sole proprietor, officer, director or partner of another person; or receiving compensation, or having the reasonable expectation of compensation, from any other person as a result of the activity.

“Similar to current Rule 3270, the proposed rule would apply only to the outside activities of registered persons. It would not apply to the activities of members’ non-registered associated persons because the risk of potential conflicts is more prevalent with regard to registered persons,” FINRA concludes. “However, the proposed rule would not preclude members from instituting policies and procedures relating to the outside activities of associated persons more broadly.”

Rule change could trigger compensation relegations

Asked to interpret the possible outcomes of such a rule change, Jason Roberts, CEO of the Pension Resource Institute, says it is likely that, if the final rule reflects the basic tenants of the proposed rule, many plan advisers who serve plans through an independent registered investment adviser [RIA] (as opposed to the broker/dealer’s “corporate” RIA) will seek to renegotiate their compensation arrangements relating to their independent RIA revenue.

“Currently, many broker/dealers charge a ‘haircut’ for supervising and, in some cases, facilitating select compliance-related functions related to the adviser’s role in the independent RIA,” Roberts notes. “The proposed test for the required risk assessment, which the B/D must perform before approving the outside, investment-related business activity, should allow many independent investment adviser representatives (IARs) to argue that their institutional plan clients are sufficiently distinguishable from their individual clients (who may also be clients of the B/D) such that they may not be required to be supervised by the B/D.”

For those who successfully make the case, Roberts argues, they should be able to eliminate or lower the haircut charged by the B/D, at least to the extent it was previously imposed for supervisory purposes.

“In other words, if the plans have no relationship with the B/D, other than the fact that their independent RIA plan adviser happens to work with individual clients through an unaffiliated B/D, then it would be hard for the B/D to argue that the adviser’s services would negatively impact the B/D’s customers or the investing public,” Roberts says. “It will also allow more plan advisers to serve plans in a discretionary, aka 3(38), capacity. The current rules (specifically, 3280) require B/Ds to supervise their registered reps’ business when the rep, who is acting as an IAR for an independent RIA, places trades for the client with any firm (i.e., an unaffiliated recordkeeper or custodian) other than their B/D. Notably, the language below is not included in the proposed rule that would replace FINRA Rule 3280: ‘If the member approves a person’s participation [that relates to the rep placing trades with firms other than his/her B/D], the transaction shall be recorded on the books and records of the [B/D] and the member shall supervise the person’s participation in the transaction as if the transaction were executed on behalf of the member.’”

According to Roberts, this rule has been the chief impediment for a significant percentage of plan advisers that would like to offer discretionary, investment-related services to their plan clients.

“If this condition no longer applies, then we can expect to see a marked shift in the marketplace as we see plan sponsors increasingly looking to outsource fiduciary functions,” Roberts concludes. “I would strongly encourage advisers to conduct their own risk assessments before taking action in response to changes emanating from a final rule.”

In some cases, Roberts says, the independent RIA is more reliant than it may first appear on compliance-related support provided by their B/D.

“Also, adding discretionary, ERISA fiduciary services requires new agreements, disclosures, policies/procedures, E&O coverage, etc.,” he explains. “I expect we will also see B/Ds, which currently derive a significant amount of revenue from these supervisory/haircut arrangements, moving to expand the scope of retirement plan-related compliance and practice management resources they offer to independent RIAs. We have a number of member firms that are already doing this and more that are evaluating how best to support plan advisers generally.”