2017 EXAMINATION FINDINGS REPORT

December 6, 2017

Outside Business Activities and Private Securities Transactions

FINRA Rules 3270 and 3280 require registered representatives to notify their firms of proposed outside business activities (OBAs), and all associated persons to notify their firms of proposed private securities transactions (PSTs), so firms can determine whether to limit or allow those activities to proceed. Certain OBAs and PSTs could potentially involve misconduct or create conflicts of interest that may expose both firms and customers to potential risks. The notifications required in the rules assist firms in identifying and determining how to mitigate those risks, including by placing conditions on, or prohibiting, participation in the proposed OBA or PST.5

Firms that had effective programs to manage OBAs and PSTs typically implemented proactive compliance efforts, particularly at the branch level. Firms used frequent training to make registered or associated persons aware of their responsibilities with respect to OBAs and PSTs, including the requirements to provide a firm prior written notice of a proposed activity. Firms also required these individuals to complete open-ended questionnaires and attestations regarding their involvement—or potential involvement—in OBAs and PSTs on a regular basis. Firms implemented various tools to identify individuals involved in undeclared OBAs and PSTs, including monitoring correspondence, fund movements, marketing materials, employee online activities and customer complaints. This also included monitoring for evidence of involvement in OBAs or PSTs the firm had prohibited.

Selected Examination Findings

FINRA observed instances in all sizes of retail brokerage firms in which registered persons, other associated persons or firms failed to meet one or more of their obligations under the rules. These instances include problems related to:

  • Notice – FINRA observed that some individuals failed to notify their firms of proposed OBAs or PSTs, including situations where a new hire or current registered or associated person failed to notify their prospective or current firm in writing of an existing OBA or PST. In some cases, individuals did not understand what constitutes an OBA or PST, or did not satisfy important provisions of the rules (e.g., the requirement for written rather than verbal notice). In other cases, individuals failed to provide the information with sufficient detail for a firm to make an adequate determination as to whether to allow a proposed OBA or PST to proceed.
  • OBA and PST Notice Reviews – FINRA observed weaknesses in some firms’ OBA and PST reviews. In some instances, firms either did not have written supervisory procedures for such reviews or the procedures were inadequate. FINRA also observed instances where firms had well-designed procedures, but executed them poorly, either through a lack of supporting documentation or a failure to execute their reviews with sufficient depth. In particular, some firms construed “compensation” too narrowly, erroneously determined that an activity was not a PST, or approved participation in a proposed transaction without adequately considering whether they could supervise the transaction as if it were executed on their own behalf.
  • Post-PST Approval – FINRA observed several problems once firms decided to approve PSTs for compensation. Some firms did not fully understand the activity and, as a result, failed to supervise it effectively. Other firms did not retain the documentation necessary to demonstrate their compliance with the supervisory obligations. In addition, firms sometimes had difficulty recording the transactions on their books and records because PSTs can take many forms and the uniqueness of their structures may not fit easily into firm electronic systems that are designed with fields tailored to a firm’s existing business.6 Some firms failed to monitor limitations placed on the PST, such as a prohibition on a registered representative soliciting firm clients to participate in the PST.

End Notes

5 On May 15, FINRA published Regulatory Notice 17-20 announcing that FINRA is conducting a retrospective review of the OBA and PST rules and requesting public comment on them. That request was made in the context of FINRA's ongoing effort to review "significant rules to ensure they remain effective at protecting investors in an efficient manner."

6 NASD Notice to Members 96-33 notes that a firm is "not required to record the activity in the same manner it records transactions executed on behalf of its own firm (i.e., on its purchase and sales blotter). Rather, members may develop and use alternative approaches that meet their specific needs and business practices..."