The Financial Industry Regulatory Authority (“FINRA”) has resubmitted to the Securities and Exchange Commission (“SEC”) a proposal to consolidate and revise legacy NASD and NYSE supervision rules.1 FINRA first proposed consolidated supervision rules in May 2008.2 It received close to fifty comment letters in response to that initial proposal. Three years later, in June 2011, FINRA filed with the SEC a proposed rule change that addressed comments received in 2008.3 The SEC received twelve comment letters in response to that proposal, but FINRA withdrew the proposal before responding to the comments. FINRA has now re-proposed the consolidated rules in a filing that largely tracks the 2008 and 2011 proposed rules.
The proposed rules preserve many familiar features of existing supervisory obligations, but also contain significant changes that member firms will want to consider carefully.4 In the proposed rules, FINRA places new emphasis on limiting conflicts of interest in the supervisory process by adopting express requirements on the supervision of supervisors and top producers.
Certain other changes have the potential to add burden and may warrant comment. Those include: (1) a requirement (adopted from the NYSE Rules) that members engaged in investment banking file quarterly reports with FINRA describing internal investigations of possible insider trading or other manipulative conduct, and that they report to FINRA within 5 days if an internal investigation determines that insider trading or other manipulation occurred (Proposed FINRA Rule 3110(d)); (2) that members with $200 million or more in annual gross revenue annually provide to senior management a tabulation of reports to FINRA of customer complaints and internal investigations and provide commentary on compliance efforts in trading and markets, investment banking, antifraud and sales practices, finance and operations, supervision, and anti-money laundering (Proposed FINRA Rule 3120)); and (3) that members acknowledge all written customer complaints, in advance of responding to them (Proposed FINRA Rule 3110(b)(5)).
Familiar Core Supervisory Obligations
The core supervisory structure in the current rules would survive in proposed FINRA Rule 3110:
Although the core supervisory requirements would remain largely unchanged, there are some significant differences between the existing rule and the proposed one.
Proposed FINRA Rule 3110(a) (Supervisory System)
The most significant additions in proposed Rule 3110(a) are in Supplementary Material .03 and .04, addressing OSJ supervision. “Codifying existing guidance,” Supplementary Material 0.3 would forbid an on-site principal from supervising his or her own sales activities and require that the on-site principal be supervised by another appropriately registered “senior principal.” The senior principal would be required to conduct periodic on-site supervision with the frequency determined by the “nature and complexity of the securities activities for which the location is responsible, the nature and extent of contact with customers, and the disciplinary history of the on-site principal.” FINRA, in responding to comments, acknowledged the role that electronic supervision plays and the burden on-site supervision might place on members using an independent broker model, but held firm in its belief that self-supervision, including even basic compliance tasks, by an on-site principal presents too great a threat of a conflict of interest.
Supplementary Material .04 expands on the requirement that at least one principal be designated to supervise each OSJ, by requiring the supervisory principal to be regularly and routinely present at the OSJ. “Consequently” the Supplementary Material concludes, “there is a general presumption that a principal will not be designated and assigned to be the on-site supervisor . . . to supervise more than one OSJ.” The Supplementary Material provides a list of factors (experience and training, time and capacity, supervisor’s own production, relative location of OSJs, and nature of business in each office) a member must weigh if it determines it is necessary to assign a single principal to supervise more than one OSJ. If a principal is assigned to more than one OSJ, the member will be required to document the factors used in determining that the supervisory structure is reasonable.
Two other smaller changes bear mention: proposed Supplementary Material .05 codifies guidance requiring that members conducting compliance meetings remotely take steps to ensure that each registered person attends the entire meeting, such as by asking questions and receiving responses during the training; proposed FINRA Rule 3110(a)(3) consolidates into the supervisory rule the requirement that a member’s main office be registered and designated as an OSJ (a requirement currently contained in IM-1000-4, which the proposal eliminates).
FINRA is no longer pursuing a requirement, found in previously proposed supplementary material, that members supervise business lines other than those requiring broker-dealer registration. Commenters had objected that the provision would exceed FINRA’s jurisdiction by, for example, extending its supervisory requirements to investment adviser affiliates.
Proposed FINRA Rule 3110(b) (Written Procedures)
Proposed FINRA Rule 3110(b), in cataloging the topics that must be covered by a firm’s written procedures, would make several changes.
Review of transactions. Proposed FINRA Rule 3110(b)(2) will continue the requirement of NASD Rule 3010(d)(1) that all transactions be subject to principal review, evidenced in writing, but “clarifies” that the requirement applies to the member’s securities and investment banking business. Supplementary Material .06 would, however, allow members to use a “risk-based review.” FINRA describes “risk-based” review in the filing as “the type of methodology a member may use to identify and prioritize for review those areas that pose the greatest risk of potential securities laws and SRO rule violations.” This contemplates “a reasonable sampling of information in which the sample is designed to discern the degree of overall compliance, the areas that pose the greatest numbers and risks of violation, and any possibly needed changes to firm policies and procedures.” FINRA’s proposal incorporates risk-based sampling in review of transactions and correspondence, reflecting its belief that such review will ensure that problem areas are identified more quickly.
Supervision of correspondence. Rule 3110(b)(4)5 and Supplementary Material 0.7 would retain the existing requirement that communications with the public be supervised, and updates the rule by incorporating guidance concerning the supervision of electronic communications given in Regulatory Notice 07-59 (December 2007), including the use of risk-based principles in structuring the supervision. In a bit of a circular fashion, the rule would expressly require review of internal communications to “identify those communications that are of a subject matter that require review under FINRA and MSRB rules and federal securities laws.” FINRA provided four examples in the rule filing: (1) communications between non-research and research departments concerning the content of a research report; (2) communications with the public that require principal pre-approval; (3) communications regarding the identification and reporting of customer complaints to FINRA; and (4) communications regarding approval for changes in account names and designations regarding customer orders. Reasonably read, the proposed rule is meant to require procedures sufficient to identify communications requiring further review. The rule would also require use of risk-based principles to determine whether additional policies and procedures are required for reviewing internal communications that do not concern a subject matter requiring review under FINRA and MSRB rules and federal securities laws.
Proposed Supplementary Material .09 would expressly allow a registered principal to delegate the review function, even to an unregistered person, while retaining ultimate responsibility for reviews. Proposed Supplementary Material .08 would codify FINRA guidance that opening a communication without more is insufficient review. Members are required to identify what communication was reviewed, who reviewed it, the date of review, and actions taken by the member if significant regulatory issues were identified by the review.
Customer complaints. Proposed FINRA Rule 3110(b)(5), adopting the requirements in NYSE Rule 401A, would require procedures to capture, acknowledge, and respond to all written — including electronic — customer complaints. No deadline for acknowledging customer complaints is included in the proposed rule, but FINRA’s rule filing suggests that members would have to explain the reasonableness of a period longer than 30 days.
Supervision of supervisors. To the existing requirement that members document their supervisory system including recording the title, registration status, location, and responsibilities of supervisory personnel, proposed FINRA Rule 3110(b)(6) adds a new provision to address potential abuses in the supervision of supervisors. Replacing NASD Rule 3012(a)(2), which addresses supervision of a producing manager’s customer accounts and requires heightened supervision when a producing manager’s revenues pass a specified threshold, the proposed rule adds new requirements barring supervisors from supervising their own activities and from reporting to, or having compensation or continued employment determined by,6 someone they supervise. The proposed rule creates a narrow exception if a member’s size or a supervisor’s position in the firm makes these requirements impossible. A member would not have to notify FINRA of its reliance on the exception, but would have to document the factors it used to determine that the exception applies and how its supervisory arrangement will otherwise comport with the rule. Proposed Supplementary Material .11 explains that the exception will generally apply only to a sole proprietor in a single-person firm or where the supervisor is a senior executive.
To these restrictions, the rule adds a new requirement that the firm’s procedures prevent “the standards of supervision . . . from being reduced in any manner, due to conflicts of interest that may be present with respect to the associated person being supervised, including the position of such person, the revenue such person generates for the firm, or any compensation” that the supervisor “may derive from the associated person being supervised.”
Maintenance of written procedures. Proposed FINRA Rule 3110(b)(7) retains all the existing requirements that procedures be made available and that they be promptly updated and communicated to associated persons. Proposed Supplementary Material .12 would expressly allow a member to communicate written supervisory procedures and amendments electronically, subject to several enumerated requirements.
Proposed FINRA Rule 3110(c) (Internal Inspections)
FINRA’s proposed rule largely keeps the existing office inspection requirements, with some notable changes. Supplementary Material .13 retains the standards for reasonable review currently in NASD IM-3010-1 (which had already been harmonized with the requirements in Incorporated NYSE Rule 342.10). The current requirement that members review “customer accounts serviced by branch office managers” has, however, been replaced with a broader requirement that “supervision of supervisory personnel” be examined.
The proposal would also expand the existing requirement to review transmittals of funds between customers and representatives and customers and third parties, by adding transmittals to any third party, any outside accounts, and any location other than the customer’s primary residence. Firms would also be required to examine how changes in customer account information — including address and account objectives — are handled. The proposal would further require firms to adopt policies and procedures for “customer confirmation, notification, or follow up that can be documented” for these transmittals and account changes (the latter are to be consistent with Rule 17a-3(a)(17)(i)(B)(2) & (3)).
Perhaps the biggest proposed change to the inspection requirements would be with regard to who may conduct inspections. The proposal retains the requirement that the inspector not be assigned to the location being inspected or supervised by a person assigned to that location, but adds a broader requirement that firms “prevent the inspection standards . . . from being reduced in any manner due to any conflicts of interest . . . including . . . economic, commercial, or financial interest in the associated persons and businesses.” With this broader requirement, the proposed rule eliminates the current (much narrower) requirement that certain branch offices be subject to “heightened office inspections.” This might present the thorny scenario of potentially requiring a main office, as an OSJ, to be inspected by someone from outside the main office. The proposal, however, does retain an exception allowing single office firms and firms where “small or single-person offices report directly to an OSJ manager who is also considered the office’s branch office manager” to use inspectors assigned to the location or supervised by a person assigned to the location, if the member documents in the inspection report the basis for assigning that individual and how the firm has otherwise complied with the rule’s requirements.
Finally, FINRA’s proposal keeps the existing examination schedule — annual review for OSJs and branches that supervise non-branch locations, at least every three years for other branches, and “on a regular periodic basis” for non-branch locations — but adds, in Supplementary Material .14, a presumption that a non-branch office will be inspected at least every three years. Members may rebut this presumption if they document in their written supervisory and inspection procedures the factors used in determining that a longer inspection cycle is appropriate.
Proposed FINRA Rule 3110(d) (Transaction Review and Investigation)
Proposed Rule 3110(d) adopts and expands the requirement in Incorporated NYSE Rule 342.21 that members implement supervisory procedures to review trading in their associated persons’ personal accounts and in other “covered accounts” to identify possible insider trading and other manipulative conduct, and to “promptly” investigate any suspect trades. Covered accounts are those “held by a spouse, domestic partner, child, parent, sibling, son-in-law, daughter-in-law, father-in-law, or mother-in-law” of an associated person “where such account is introduced or carried by the member;” “introduced or carried by the member in which a person associated with the member has a beneficial interest;” “introduced or carried by the member over which a person associated with the member has the authority to make investment decisions;” or that are “disclosed to the member pursuant to NASD Rule 3050 or NYSE Rule 407.”
The proposal would add a requirement (similar to the one currently in Incorporated NYSE Rule 351(e)) that members that engage in investment banking services file quarterly written reports with FINRA, signed by a senior officer, “describing each internal investigation initiated in the previous calendar quarter” regardless of whether the investigation is complete and whether the firm concluded that wrongdoing had occurred. The reports will be required to identify (1) the member; (2) the date each internal investigation commenced and its status; (3) the resolution (if closed); (4) the security and trades at issue; (5) the accounts, the associated person, or the family members involved; and (6) a copy of the member’s policies and procedures adopted under the rule. In addition to the quarterly reports, firms engaged in investment banking will be required to report to FINRA within 5 days of completing an internal investigation in which they conclude insider trading or manipulation occurred. The report will be required to describe the investigation and its results, as well as disciplinary action taken and whether a regulatory referral was made. Investment banking services are broadly defined to include acting as an underwriter or participating in a selling group; acting as a financial adviser in a merger or acquisition; providing venture capital or equity lines of credit or serving as placement agent for an issuer.
Proposed Rules 3120 and 3150
The proposal also relocates several existing provisions into two new rules. Proposed FINRA Rule 3120 would replace NASD Rule 3012’s testing and verification of supervisory procedures requirements, including the requirement to report to senior management annually with a summary of the test results and any necessary changes. The proposal, however, adopting a provision from Incorporated NYSE Rule 342.30, would add a requirement that members with $200 million or more in gross revenue provide to senior management a “tabulation” of reports made to FINRA on complaints and internal investigations and a “discussion” of compliance efforts in six areas: trading and markets, investment banking, antifraud and sales practices, finance and operations, supervision, and anti-money laundering.
Proposed FINRA Rule 3150 would replace NASD Rule 3110(i) and eliminate the strict time limits for holding a customer’s mail. The rule would allow a member to hold mail for a customer if the customer will not be receiving mail at his or her usual address if the member meets certain conditions, including receiving written instructions from the customer that includes the time period during which the member is requested to hold the customer’s mail, advising the customer in writing — with confirmation from the customer — of the ability to access account information electronically, and verifying with the customer at reasonable intervals that the instructions still apply. Members would be required to be able to reach the customer in the timely manner to communicate important account information.
The filing of this rule proposal is something of a milestone in moving FINRA’s rule consolidation process closer to the finish line. The proposed changes are, for the most part, incremental, requiring additional reporting and review in some areas (e.g. investment banking). That said, the rule marks a clear effort by FINRA to curtail perceived conflicts of interest within firms’ supervisory systems, with the greatest potential impact likely to fall on very small firms and firms with an independent branch model. For those firms, the rule changes could require review, and possibly significant revisions to parts of their supervisory structure. Although FINRA has now, effectively, responded to two rounds of comments, firms seeking to comment will have an opportunity to do so.
If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:Burke-Timothy
1 See SR-FINRA-2013-025 (June 14, 2013).
2 See Regulatory Notice 08-24 (May 2008).
3 See SR-FINRA-2011-028 (June 10, 2011).
4 There will be an opportunity for public comment on the proposed rules upon the SEC’s publication of them in the Federal Register.
5 FINRA is reserving Proposed FINRA Rule 3110(b)(3), concerning outside business activities, for a separate rulemaking.
6 While FINRA, in the filing, describes this requirement as new, it is in keeping with the SEC’s view concerning impermissible conflicts of interest, as expressed in cases like the Gruttadauria matter. See, e.g., SG Cowen and Lehman Brothers Settle Enforcement Actions with SEC and NYSE for Supervisory Failures in Frank Gruttadauria Case, SEC Press Release 2003-96 (Aug. 14, 2003).
This article was originally published by Bingham McCutchen LLP.