The Overview addresses, among other things, categories of information and other factors that firms should consider when assessing materiality of prospective business initiatives.
Broker-dealers often ask us whether they must seek approval from the Financial Industry Regulatory Authority (FINRA) to expand the lines of business in which they are approved to engage. A determination of whether approval is required for an expansion is based on NASD Rule 1017 (Rule 1017) and can require filing a Continuing Membership Application (CMA). A Materiality Consultation with FINRA is a corollary to the CMA process and sometimes a precursor thereto. A Materiality Consultation is a voluntary process that can help a firm determine whether a CMA is required and, in our experience, in many instances, allows a firm to avoid the far more burdensome CMA. For the first time in more than a decade, FINRA recently provided guidance in the form of an overview (Overview) of the Materiality Consultation process, including criteria that firms should consider, categories of information that firms should include in a Materiality Consultation, and certain administrative aspects of the Materiality Consultation process.
A firm’s ability to proceed with a new business line or other business initiative without first receiving FINRA approval is based largely on a fact-specific analysis that hinges on whether the prospective change is “material.” A “material change in business operations” includes, but is not limited to, (1) removing or modifying a membership agreement restriction; (2) market making, underwriting, or acting as a dealer for the first time; or (3) adding business activities that require a higher minimum net capital under Rule 15c3-1 under the Securities Exchange Act of 1934. These three categories address only a limited segment of the scope of business initiatives that a broker-dealer might pursue that could constitute a material change to its business operations.
The Overview of the Materiality Consultation process reiterated several categories of information identified in Notice to Members 00-73 that firms should consider when assessing materiality of prospective business initiatives, including the following:
We have found that FINRA takes a broad view of what may constitute a material change to a firm’s business, and there can be a substantial gap between the definition of “material change of business” and those real-world business initiatives that FINRA considers material changes. The Materiality Consultation process is designed for a firm that is uncertain as to whether its prospective business initiative would constitute a material change under FINRA’s rules and standards, and, therefore, whether the firm is able to proceed without FINRA’s blessing. A Materiality Consultation provides firms with the opportunity to formally seek FINRA’s guidance in this respect. A firm that pursues a Materiality Consultation should provide a thorough description of the proposed change in business that will permit FINRA staff to understand the scope of the business and how it will be conducted.
The Overview identifies a nonexhaustive list of information that a firm should provide that is substantially the same as the categories of information from Notice to Members 00-73, but that also includes background on the firm’s disciplinary history, as applicable, related to the proposed activities. This background history may help FINRA decide whether the firm’s overall prior disciplinary or other regulatory history may affect its ability to effectively engage in the new business. This indicates that FINRA in its discretion may consider any such disciplinary history in determining whether a CMA is required.
The Overview reminds firms that a prospective business expansion that relates to unique, novel, or complex products or platforms could be considered material. FINRA also notes that industry guidance and other related materials, including investor alerts and FINRA’s Examination Priorities Letter, will likely be considered when determining materiality of a proposed change in a firm’s business. The Overview also addresses certain administrative aspects of the Materiality Consultation process, including the following:
FINRA rules provide limited direction regarding whether a member’s prospective business expansion would first require FINRA approval as a material change in business operations. FINRA has provided minimal guidance in this area outside of its rules (i.e., Notice to Members 00-73). The Overview is helpful in assisting members with determining whether they should begin the CMA process or instead seek FINRA’s input through a Materiality Consultation. Despite the new guidance, because there is no clarity as to what FINRA may consider a “material change,” firms will still have to analyze potential changes in the scope of their businesses on a case-by-case basis.
As a result, FINRA members should continue to carefully consider the scope of their existing, approved business lines before expanding their activities. This includes considering the information provided to FINRA during the new membership application process and any subsequent CMAs, as applicable, and during the examination process. The Overview includes a cautionary note for FINRA members that choose to neither submit a CMA nor seek a Materiality Consultation with FINRA and that instead determine on their own that their prospective changes would not be “material”—FINRA urges such firms to document the reason(s) and analysis for the conclusion that the changes are not material as part of their books and records to support potential inquiries during future examinations, which suggests that FINRA will look closely at business changes and expansions and related approvals. If FINRA staff subsequently determines that the business expansion was material, a firm that neither submitted a CMA nor sought a Materiality Consultation could become subject to disciplinary action.
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. Rule 1017 exists under the legacy NASD rulebook. Rule 1017 addresses a FINRA member’s application for approval of change in ownership, control, or business operations. Among other things, Rule 1017 specifies requirements related to the CMA process, timelines that surround FINRA’s follow-up questions and a firm’s response thereto, potential membership interviews with FINRA, and FINRA’s ultimate decision on the CMA.
. See NASD Rule 1011(k).
. This contrasts with FINRA’s treatment of disciplinary history under the Safe Harbor in NASD IM-1011-1. Under that provision, only certain enumerated disciplinary violations prevent a firm from taking advantage of the Safe Harbor for business expansions.