Introduction
On December 30, 2014, the Securities and Exchange Commission (“SEC”) approved a new Financial Industry Regulatory Authority (“FINRA”) rule governing transaction-based payments to unregistered persons. The new FINRA rule—Rule 2040—became effective on August 24, 2015. If you are a FINRA-registered broker-dealer that currently pays an unregistered person, now is a perfect time to examine the relationship and make sure that these payments are proper. In addition, if you are an unregistered or unlicensed person, then you may want to make sure that you can receive or continue receiving these payments. Lastly, if your firm permits “selling groups” of registered representatives for expense paying and marketing purposes, it is also a good time to reassess these practices.
More specifically, this new rule addresses many situations that can arise in a broker-dealer’s regular course of business. These situations include, but are not limited to:
- Asset purchase arrangements between current representatives;
- The receipt of continuing compensation by retiring representatives, their beneficiaries, or estates; and,
- Referral arrangements.
As a result of these new changes, the current FINRA rules addressing payments to non-registered persons, as well as related New York Stock Exchange rules have been deleted from the FINRA rulebook. The rest of this article deals specifically with the requirements and implications of Rule 2040 and Section 15(a) of the Securities Exchange Act (the “Exchange Act”).
The Rule
Rule 2040(a) states, “[n]o member or associated person shall, directly or indirectly, pay any compensation, fees, concessions, discounts, commissions or other allowances to: (1) any person that is not registered as a broker-dealer under Section 15(a) of the Exchange Act but, by reason of receipt of any such payments and the activities related thereto, is required to be so registered under applicable federal securities laws and SEA rules and regulations; or (2) any appropriately registered associated person unless such payment complies with all applicable federal securities laws, FINRA rules and SEA rules and regulations.” In short, this paragraph states that broker-dealers cannot i) pay unregistered persons or entities, unless the payment would otherwise be legal, and ii) pay registered representatives unless the payment is legal.
To summarize paragraph (b) of the same rule, a member may pay continuing commissions to a retiring registered representative so long as a contract between the member and the retiring registered representative existed before retirement, and the retiring registered representative agrees not to solicit new business, open new accounts, or service the accounts generating the continuing commission payments. This section also requires that the payment is otherwise legal.
The rule also defines any “retiring registered representative” as an individual who leaves the securities industry. It also suggests that payments may continue to the retiring representative’s beneficiary or estate after death.
What Does it Mean for Payers and Payees of Transaction-Based Compensation?
This particular method of drafting begs the question of what is legal in terms of paying or assigning transaction-based compensation to unregistered persons or entities. However, this was not a matter of poor drafting. It was a deliberate decision, because FINRA has long deferred to the SEC to determine whether or not a person or entity should be registered as a broker-dealer.[i]
However, SEC approval no longer appears to be the only method for broker-dealers and registered representatives to prove to FINRA that they are in compliance with Section 15(a) of the Exchange Act. A supplement to Rule 2040 gives members additional guidance. This paragraph states, “FINRA expects members to determine that their proposed activities would not require the recipient of the payments to register as a broker-dealer and to reasonably support such determination (emphasis added). Members that are uncertain as to whether an unregistered person may be required to be registered under Section 15(a) of the Exchange Act by reason of receiving payments from the member can derive support for their determination by, among other things, (1) reasonably relying on previously published releases, no-action letters or interpretations from the Commission or Commission staff that apply to their facts and circumstances; (2) seeking a no-action letter from the Commission staff; or (3) obtaining a legal opinion from independent, reputable U.S. licensed counsel knowledgeable in the area. The member’s determination must be reasonable under the circumstances and should be reviewed periodically if payments to the unregistered person are ongoing in nature. In addition, a member must maintain books and records that reflect the member’s determination.”
Option one and two above will not make it very easy for a registered representative to structure the sale of his or her book of business,[ii] nor will they help a selling group operate a corporate entity for expense paying and marketing purposes.[iii] In a line of SEC Interpretive No-Action Letters, the SEC has suggested that it would reserve the right to bring enforcement proceedings against entities that receive securities-based compensation from registered representatives by assignment or otherwise.[iv] However, No-Action Letters are not binding legal authority. These letters merely serve as the opinions of the Commission on arguable questions of the law.
Conclusion
This author has personally spent countless hours conducting legal research on case law dealing with payments by a broker-dealer to a retiring representative, asset purchases between retiring representatives, the use of selling groups for estate planning, marketing, and expense sharing purposes. Not a single case could be located where the SEC tried these issues before an administrative law judge or district court arguing that these practices were in violation of Section 15(a) of the Exchange Act. It is a very prevalent practice in the industry, and if the SEC thought it had a winning argument they would most likely act on it. This is the same government agency that brought 755 enforcement actions in 2014 and collected over $4.1 billion in monetary relief in the same year.[v]
If you or your firm could benefit by receiving or paying transaction related-compensation, then that leaves you with only one option left: to prove to FINRA that your proposal is compliant with Section 15(a) of the Exchange Act. You must obtain a legal opinion from independent, reputable U.S. licensed counsel knowledgeable with commission sharing arrangements.
[i] See NASD Interpretive Letter to Ted. A. Troutman, Esquire, Muir & Troutman (Feb. 4, 2002).
[ii] See Securities Industry and Financial Markets Association (Nov. 19, 2008)(SEC grants no-action relief to a retiring representative structuring the sale of his book of business subject to more than ten conditions to be met.)
[iii] See Herbruck, Alder & Co. (May 3, 2002)(Firm denied no-action relief where all nine owners were registered representatives of a broker-dealer who would receive commission checks directly from broker-dealer, deposit them in their own personal accounts, and then write a check to the firm. The purpose of combining the revenues was that the firm could deduct “overhead, payroll taxes, and fringe benefit costs” and remit the balance to the employee(s).); Wolff Juall Investments, LLC (May 17, 2005)(No relief granted where registered representatives proposed to deposit their commissions with a limited liability corporation not registered as a broker-dealer to cover expenses with the non-registered entity to distribute the remainder to the registered representatives.); Birchtree Financial Services, Inc. (Sept. 22, 1998)(No Action Relief denied where Birchtree Financial Services requested the payment of commissions to an entity owned and operated solely by two registered representatives. Relief also denied for the assignment of commissions by the two registered representatives to an entity. The entity was created to pay operating expenses and health care benefits for employees.); Century Investment Group Incorporated (Jan. 29, 1996)(SEC Division of Market Regulation would not offer relief where certain registered representatives would create their own, single shareholder corporation to receive the individual representative’s share of securities-based compensation.); Voluntary Benefit Systems Corporation of America (Nov. 14, 1995) (Dually registered insurance agent and registered representative of a broker-dealer requested and was denied no-action request where he requested that his commission compensation be directed to an existing life insurance agency not registered as a broker-dealer.); Lombard Securities Incorporated (July 12, 1994)(SEC denied no-action relief when it requested that it be able to direct securities-based compensation directly to “service corporation” rather than make such payments individually to each registered person. All owners of the “service corporation” were proposed to be registered as associated persons of a broker-dealer.); Vanasco, Wayne & Genelly (Feb. 17, 1999)(No Action request denied where registered representatives would continue to be employed by the broker-dealer, the broker-dealer would route all trading commissions earned by the registered representatives to their respective personal service corporations, rather than directly to the individual representatives.).
[iv] See Herbruck, Alder & Co. (May 3, 2002)(Firm denied no-action relief where all nine owners were registered representatives of a broker-dealer who would receive commission checks directly from broker-dealer, deposit them in their own personal accounts, and then write a check to the firm. The purpose of combining the revenues was that the firm could deduct “overhead, payroll taxes, and fringe benefit costs” and remit the balance to the employee(s).); Wolff Juall Investments, LLC (May 17, 2005)(No relief granted where registered representatives proposed to deposit their commissions with a limited liability corporation not registered as a broker-dealer to cover expenses with the non-registered entity to distribute the remainder to the registered representatives.); Birchtree Financial Services, Inc. (Sept. 22, 1998)(No Action Relief denied where Birchtree Financial Services requested the payment of commissions to an entity owned and operated solely by two registered representatives. Relief also denied for the assignment of commissions by the two registered representatives to an entity. The entity was created to pay operating expenses and health care benefits for employees.); Century Investment Group Incorporated (Jan. 29, 1996)(SEC Division of Market Regulation would not offer relief where certain registered representatives would create their own, single shareholder corporation to receive the individual representative’s share of securities-based compensation.); Voluntary Benefit Systems Corporation of America (Nov. 14, 1995) (Dually registered insurance agent and registered representative of a broker-dealer requested and was denied no-action request where he requested that his commission compensation be directed to an existing life insurance agency not registered as a broker-dealer.); Lombard Securities Incorporated (July 12, 1994)(SEC denied no-action relief when it requested that it be able to direct securities-based compensation directly to “service corporation” rather than make such payments individually to each registered person. All owners of the “service corporation” were proposed to be registered as associated persons of a broker-dealer.); Vanasco, Wayne & Genelly (Feb. 17, 1999)(No Action request denied where registered representatives would continue to be employed by the broker-dealer, and the broker-dealer would route all trading commissions earned by the registered representatives to their respective personal service corporations, rather than directly to the individual representatives.). But see, 1st Global, Inc. (May 7, 2001)(No action request partially denied and partially granted. 1st Global Capital Corp. was a registered broker-dealer. The firm had many registered representatives who were also partners in accounting firms. The SEC granted no-action relief where 1st Global Capital Corp. would pay securities commissions to a CPA registered representative who is not subject to a formal or informal agreement requiring him to turn securities commissions over to an unregistered CPA firm, and no unregistered person would be eligible to receive commissions directly or indirectly. However the SEC denied no-action relief where 1st Global Capital Corp. would pay securities commissions to a CPA registered representative, with the understanding that the registered representative would then “voluntarily” turn those commissions over to an unregistered CPA firm.)
[v] See SEC’s FY 2014 Enforcement Actions Span Securities Industry and Include First-Ever Cases (Oct. 16, 2014), available at http://www.sec.gov/News/PressRelease/Detail/PressRelease/1370543184660.
