On March 4, 2011, FINRA filed with the SEC a rule proposal seeking to adopt FINRA Rule 1230(b)(6) which would establish a registration category and qualification examination requirement for Operations Professionals (the “rule proposal”). FINRA filed the rule proposal after receiving 49 comments from industry participants in response to its regulatory notice, RN 10-25, in which it proposed the addition of FINRA Rule 1230 (b)(6).1 See Bingham Alerts, dated June 3, 2010, and December 14, 2009.
Despite the wide range of comments received, FINRA, in the rule proposal, asks the SEC to adopt the rule with only slight modifications to the proposal in RN 10-25. In response to comments questioning the need for this new registration category, FINRA stated that it believes background checks and fingerprinting are insufficient safeguards to ensure a firm’s operations departments are functioning in a manner that will promote investor protection. Instead, according to the rule proposal, FINRA believes that the proposed rule will help ensure that any fraudulent activity that starts in the front office will not be processed if it has to pass through a properly registered and trained Operations Professional in the back office.
With the filing of this rule proposal broker-dealers should begin to determine who will be considered the “covered persons” that are responsible for “covered functions” subjecting them to registration and, possibly, the need to take a qualifying exam.
Proposed FINRA Rule 1230(b)(6)
As we described in greater detail in our earlier alert, the rule proposal seeks to amend (proposed) FINRA Rule 12302 to adopt a new representative registration category for Operations Professionals. The rule defines certain persons as “covered persons”3 and requires any covered person who is responsible for one or more “covered function”4 to register as an Operations Professional. FINRA noted in the rule proposal that “[g]enerally, covered persons would be those persons who are directly responsible for overseeing that tasks within a covered function are performed correctly in accordance with industry rules, firm protocols, policies and procedures, and who are charged with protecting the functional and control integrity of the covered functions for a member.”
A. Covered Persons Under the Rule Proposal
The categories of “covered persons” in the rule proposal have not changed from the three categories FINRA proposed in RN 10-25. In the rule proposal FINRA emphasizes that persons that perform covered functions, but who are not responsible for managing or supervising these functions, or for authorizing or approving work or committing the firm’s capital in furtherance of these functions would not be required to register as Operations Professionals.
In the rule proposal FINRA does, however, make a modest modification to the third category of covered persons (persons with authority or discretion to commit a member’s capital), by adding a requirement that the commitment of the firm’s capital be “material.” The rule proposal also adds Supplementary Material .06. The Supplementary Material expressly notes that “what constitutes ‘materially’ or ‘material’ is based on a member’s pre-established spending guidelines and risk management policies.”
B. Covered Functions
As is the case with the definitions of covered persons, in the rule proposal FINRA essentially keeps the “covered functions” that it proposed in RN 10-25, although it reordered them so that they “grouped related functions together.” FINRA also made several changes to address industry comments on the scope of the “covered functions.” We address below the changes FINRA has made from the proposal in RN 10-25.
1. Exclusion of Persons Performing Ancillary or Advisory Work
FINRA addresses in the rule proposal concerns raised in a number of comments that several of the proposed, broadly worded, covered functions would sweep up employees engaged in work that was clerical or that was a support role to a covered function. In Supplementary Material .06, FINRA clarifies that “[a]ny person whose activities are limited to performing a function ancillary to a covered function. . .or whose function is to serve a role that can be viewed as supportive of or advisory to the performance of a covered function. . .or who engages solely in clerical or ministerial activities. . .shall not be required to register as an Operations Professional.” FINRA provides the examples of “internal audit, legal or compliance personnel who review but do not have primary responsibility for any covered function” as being supportive or advisory roles that would not require registration.
2. Posting Entries to the Books and Records af a Member
In RN 10-25, FINRA included as a covered function “[p]osting entries to the books and records of a member in connection with the covered functions.” The rule proposal modifies this to “[p]osting entries to a member’s books and records in connection with a covered function to ensure integrity and compliance with the federal securities laws and regulations and FINRA rules.” Although not expressly stated in the rule proposal, the modification, presumably, clarifies that clerical staff, responsible for the mechanics of making these entries, but not for the additional supervisory function, would not be included in the new registration requirement.
3. Business Requirements for Sales and Trading Systems
RN 10-25 included as a covered function “[c]apturing of business requirements for sales and trading systems and any other systems related to the covered functions, and validation that these systems meet such business requirements.” In response to several comments, FINRA’s rule proposal eliminates “capturing” and instead, changes the function to “defining and approving business requirements for sales and trading. . .” In the rule proposal FINRA explains that it believes those covered persons who are responsible for defining and approving business system requirements are professional-level staff that should be subject to registration. This covered function, the rule proposal clarifies, would not include persons who engage in administrative responsibilities such as an initial drafter or code developer (but would include the individual supervising such activities).3
4. Financial Control and Regulatory Reporting
In RN 10-25 FINRA listed two covered functions: “[f]inancial controller (including general ledger)” and “[f]inancial regulatory reporting.” Responding to comments, FINRA explained that it does not believe that these “covered functions” will cause confusion with either the financial and operations principal or the Principal Operations Officer (proposed in Regulatory Notice 09-70) registration requirements. The rule proposal instructs that, depending on their responsibilities, some individuals may need to hold more than one registration. Nonetheless, in a tacit acknowledgement that the original presentation might have been confusing, the rule proposal changes the covered functions to “[f]inancial control including general ledger and treasury” and ”[c]ontributing to the process of preparing and filing financial regulatory reports.”
5. Pricing Models
FINRAs original proposal in RN 10-25 included as a covered function, “[d]evelopment and approval of pricing models used for valuations.” Responding to comments, in the rule proposal, FINRA eliminated “development,” limiting the function to “approval” of pricing models, and thereby clarifying that those engaged only in the development of the model will not need to register.
C. Guidance on Applicability to Outsourced and Shared Services
Notwithstanding the steps FINRA took to limit the scope of some of the covered functions and to clarify who is a covered person, the rule proposal makes it quite clear that the new registration requirement may have a broad impact, including on persons who are not employees of the member, if they are providing outsourced or shared services. Although in the rule proposal FINRA states that it is not changing the definition of “associated person,” it concludes that an individual who meets the definition of a covered person with responsibility for a covered function must register as an Operations Professional, regardless of where the person works, be it at the broker-dealer, an affiliate or a third-party service provider. FINRA notes that the proposed registration category is function-based, so persons are not shielded from its requirements based on title or employment by an entity other than the member firm.
Indeed, FINRA refused categorically to exclude insurance company functions related to variable annuity contracts as well as other functions performed by insurance company staff. As a result, all individuals and their functions will need to be scrutinized to determine whether they fall within the definitions of covered persons with responsibilities for covered functions.6
D. Exceptions to Operations Professional Examination Requirement
FINRA made no modifications to the exceptions to the Operations Professional qualification examination requirement.7 FINRA also restated that it believes a two-year look back for eligible inactive registrations is appropriate. FINRA clarified that the two-year look back is consistent with the window during which an associated person remains eligible to re-activate his or her registration based on having previously qualified for and held a registration. FINRA noted that a person who qualifies for the proposed exception based on having become deregistered within the two years immediately prior to registering as an Operations Professional would be required to first re-activate the eligible registration which would then make him or her eligible to request registration as an Operations Professional without taking the qualification exam.
FINRA decided not to incorporate a grandfather provision for previously unregistered operations personnel.
E. Transition Period
FINRA amended the transition period that it proposed in RN 10-25. Under the rule proposal, firms will now have 60 days from the effective date of the rule during which they must identify “Day-One Professionals.” Day-One Professionals are those already employed in a position for which Operations Professional registration becomes necessary. Day-One Professionals must request registration as an Operations Professional via Form U4 in CRD. The Day-One Professionals who are identified during the 60-day period and must pass the Operations Professional examination (i.e., those who are not eligible for an exam waiver based on an appropriate existing registration) will have 12 months, beginning on the effective date of the proposed rule, to pass the qualifying examination. Those individuals may function as Operations Professionals during that time.
Non-Day-One Professionals — those who take a role requiring registration after the rule’s effective date — who are associated with a clearing firm or self-clearing firm will not be permitted to function as Operations Professionals until they pass the Operations Professional qualification examination (or another eligible qualification examination). However, non-Day-One-Professionals associated with a non-clearing firm who must pass the Operations Professional qualification examination will be granted a 120-day grace period beginning on the date the person requests Operations Professional registration via Form U4 in CRD, during which they may operate as an Operations Professional.
Given the broad range of individuals that may be subject to a new registration and qualification requirement based upon their status as a covered person responsible for a covered function, broker-dealers should begin immediately to identify their Day-One Professionals, review their policies and procedures in anticipation of updating them to reflect the new registration and qualification requirement, and inform those individuals that may be impacted by the proposed new requirements.
Please direct questions to any of the listed lawyers or to any other Bingham lawyer with whom you ordinarily work on related matters.
This article was originally published by Bingham McCutchen LLP.