Most financial industry professionals are familiar with the prohibition on “selling away,” the somewhat ambiguous term contemplated by FINRA Rule 3280. FINRA Rule 3280 states that, “[n]o person associated with a member shall participate in any manner in a private securities transaction except in accordance with the requirements of this Rule.” Among other things, the Rule requires a financial advisor to provide written notice prior to participating in a private securities transaction even when the financial adviser receives no compensation.

While it is generally understood that FAs cannot sell securities to customers that are not offered by their broker-dealer without first receiving permission from the broker-dealer, much of the guidance around this rule focuses on what qualifies as a private securities transaction (a term that is arguably poorly defined in the Rule). Many financial advisers, however, are unaware of how broadly FINRA interprets what it means to “participate” in a private securities transaction.

FINRA recently made a determination (not yet publicly released) that a registered representative “participated” in a private securities transaction because he; a) set up a zoom conference call between the outside fund manager and the investor, b) forwarded the original offering materials to the investor, and c) forwarded amended offering materials approximately a year after the original investment.

To support the determination that this level of involvement constituted participation, FINRA’s Staff cited a footnote in a 21-year-old notice to members which states the following:

Associated persons are reminded that “participation” in a securities transaction includes not only making the sale, but referring customers, introducing customers to the issuer, arranging and/or participating in meetings between customers and the issuer, or receiving a referral or finder’s fee from the issuer.

NTM 01-79 n. 7.

FINRA’s Staff also cited In the Matter of the Application of Mark H. Love, Exchange Act Release No. 49248 (Feb 13, 2004). In Love, the financial adviser introduced several customers to the manager of a fund but the SEC found he did much more than just pass along a telephone number. “He effectively vouched” for the fund manager. Love told at least one client that he was personally interested in investing in the fund. Love also facilitated transfers of funds from his client’s brokerage accounts to the fund and when the fund became illiquid, Love interceded on his clients’ behalf.

The SEC in Love emphasized that the word “participate” should be read broadly. To support this, however, the Commission cited to two SEC actions involving reps who received compensation for referring customers to an outside investment. Thus, the question of their participation was never really in question at all.

Most interestingly, the SEC said the following:

we wish to emphasize that a broker who does nothing more than refer a customer to another investment opportunity should not ordinarily run afoul of Rule 3040 [now Rule 3280], where, as here, the broker becomes involved in a customer’s investment choice through a specific recommendation and by facilitating the mechanics of transactions, we believe that such participation fits within the broad range of behavior prohibited by Rule 3040.

(Emphasis added). This seems to directly contradict the footnote cited by FINRA in NTM 01-79 which states that merely “introducing customers to the issuer” could be deemed “participation.”

While the current guidance from regulators is far from clear, there are some common elements in instances in which regulators found that financial advisors violated FINRA Rule 3280 even when the financial advisors did not receive compensation or invest in the securities themselves. Here are some examples of actions that lead to a finding of “participation:” a) facilitating the investment by moving funds from the clients’ brokerage accounts or by delivering checks, b) delivering offering documents to or from the outside issuer, c) indicating that the adviser is interested in the investment, or d) acting as an intermediary between the issuer and the clients.

Ultimately, as in most compliance related matters, it always wise not to leave yourself at the mercy of how the regulators interpret a word such as “participate.” It is also wise not to take the SEC statement at face value that, “a broker who does nothing more than refer a customer to another investment opportunity should not ordinarily run afoul of Rule 3040.” Financial advisers should trust that FINRA will always find “something more” than a mere introduction and require disclosure of such introductions, in writing, to their firm.

Herskovits PLLC has a nationwide practice defending FINRA investigations and disciplinary proceedings. Feel free to contact us at (212)897-5410.

FINRA recently published its 2022 Report on FINRA’s Examination and Risk Monitoring Program to provide member firms with guidance and insights gathered by FINRA’s Examinations and Risk Monitoring programs over the course of the year. The report also serves to inform firms what FINRA sees as “emerging” compliance risks that FINRA’s Examinations and Risk Monitoring programs intend to focus on for 2022.

Among the various areas covered by the report is a section addressing outside business activities (“OBAs”) (FINRA Rule 3270) and private securities transactions (“PSTs”) (FINRA Rule 3280). FINRA noted in its “Exam Findings” section a number of common mistakes being made by firms.

FINRA Rule 3270 requires registered representatives to notify their firms in writing of any proposed outside business activity. Member firms are then required to “evaluate the advisability of imposing specific conditions or limitations on a registered person’s outside business activity, including where circumstances warrant, prohibiting the activity.”

FINRA Rule 3280 requires registered representatives to notify their firms in writing of any proposed PST and get firm approval for any PST for which the registered representative will receive compensation. A firm approving a PST where the associated person has or may receive selling compensation must record and supervise the transaction as if it were executed on behalf of the firm.

Exam Findings

The first finding concerned the failure to properly interpret the rules. FINRA found that firms were interpreting “compensation” too narrowly and not taking into account such things as the registered representatives’ receipt of membership interests, preferred stock or even tax benefits. FINRA found instances where no notice of an OBA or a PST was provided which is an obvious rule violation. FINRA also found that firms were not retaining the necessary documents to demonstrate compliance with the rule, such as documentation of the review, approval or disapproval of OBA and PST notices.

Where firms’ approvals contained limitations, such as not soliciting firm clients, FINRA found that firms failed to monitor if these limitations were being followed. FINRA also found that firms were incorrectly assuming that all digital assets were not securities and therefore not categorizing certain transaction as PSTs.

FINRA Recommended “Effective Practices”

Not surprisingly, FINRA suggests that registered representative be required to complete periodic questionnaires regarding their involvement or potential involvement in any PST or OBA. This would seem to be a fairly universal practice among firms. As a side note, “potential involvement” is an area that gets many financial advisors in trouble. Approval must be sought before any action is taken by the registered representative. It is not uncommon for a registered representative to set up a company for some future, sometimes even unknown, purpose. Even if the company is inactive, it must be disclosed before it is formed.

Some of FINRAs other suggested practices are a bit more extreme. For example, Firms may be surprised to find that FINRA expects them to not only review the PST or OBA at the time of disclosure but continue to monitor it through periodic reviews of social media, internet websites, e-mails and interviews of registered representatives.

FINRA also suggests monitoring the other “red flags” such as the changes in a registered representatives’ “performance, production levels or lifestyle . . . .” FINRA recommends regular, periodic background check and reviews of such things as bank statements and tax returns.

Key Takeaways

It seems likely that few firms have procedures in place for monitoring OBAs and PSTs that include “regular, periodic background checks” or regular reviews of registered representatives’ tax returns and bank statements or “lifestyle.” Similarly, it is hard to envision a firm that regularly reviews registered representatives’ social media accounts. Indeed, at larger firms, such monitoring and supervision would likely be a full time job for several employees. That being said, FINRA’s report makes it clear that firms must do more than simply having registered representatives fill out an annual questionnaire. FINRA also makes it clear that, even if a firm conducts a thorough review at the time of approval an OBA or PST, a firm must also having procedures in place to continue to monitor and supervise that OBA or PST after that initial approval.

Herskovits PLLC has a nationwide practice defending against FINRA investigations and disciplinary proceedings. Feel free to contact us at (212) 897-5410 for a consultation.

Maybe it’s just me, but it feels like FINRA has ramped up its caseload for undisclosed outside business activities and unapproved private securities transactions. This week alone, FINRA resolved two such cases in FINRA Matter No. 2018058026701, Alexander Jon James and FINRA Matter No. 2019061490801, Barry Robert Bode. Before analyzing the cases, it’s worth re-visiting the scope of these rules:

FINRA Rule 3270 (Outside Business Activities)

The rule is designed to prevent FAs from engaging in outside business activities absent written approval from the member firm. Generally speaking, the rule does not apply to the registered person’s personal passive investments (e.g., buying away) and activities conducted on behalf of a member firm’s affiliate (e.g., work for an affiliated investment advisory firm or insurance arm). Examples of reportable outside business activities could include providing accounting or consulting services, working for a start-up or sitting on a board of directors, acting as a real estate broker, and serving on the board of a religious or civic organization, among other things.

FINRA Rule 3280 (Private Securities Transactions)

Private securities transactions are transactions outside the regular scope of the FAs employment. Excluded from this broad rule are transactions subject to FINRA Rule 3210 (meaning, accounts at other broker-dealers and financial institutions), transactions among immediate family members without any selling compensation, and personal transactions in investment company and variable annuity securities. For those transaction covered by this rule, the FA is required to provide written notice to his employer and indicate his role in the transaction and he has received or may receive compensation. “Selling away” violations are typically covered by this rule.

Alexander Jon James — FINRA Matter No. 2018058026701

Alexander James was formerly associated with Voya Financial Advisors, Inc. According to FINRA, from January 2013 through July 2016, James engaged in an undisclosed outside business activity by forming and incorporating a company that charged users a monthly subscription fee for access to a website that could be used to seek funding for ventures. Apparently, James helped run the day-to-day operations and was paid $16,000 for his services. James’ arguably more serious violation was his decision to solicit 2 customers to invest a total of $667,000 in his company. This conduct causes obvious litigation risk for a broker-dealer since the customer may have believed the investment was vetted by the firm. According to BrokerCheck, one of James’ customers complained about an “unapproved, outside investment” which resulted in a $75,000 settlement. As a result of FINRAs alleged violations, James consented to a 1 year suspension and a fine of $10,000.

Barry Robert Bode — FINRA Matter No. 201906140801

Barry Bode was formerly registered with The O.N. Equity Sales Company. He was discharged by the firm in early 2019 for allegedly engaging “in an unapproved outside business activity related to the negotiation and sale of mineral rights on behalf of a client for compensation.”

According to FINRA, Bode violated Rule 3270 (outside business activity rule) by (a) forming an LLC and servicing as managing partner without notice to the member firm; (b) performing business consulting services that resulted in $7,000 of consulting fees; (c) contracting with an individual to market the mineral rights associated with property in Colorado; and (d) soliciting offers to purchase the mineral rights from energy and mineral companies. Although, according to FINRA, Bode ultimately submitted an outside business activity disclosure form, Bode failed to disclose the existence of the LLC or his role in it, or that he entered into contract to market, or that he, in fact, marketed the mineral rights. According to FINRA, Bode misled his employer failing to acknowledge that he had been a fee of $12,000 for his work in connection with the mineral rights. As a result of FINRAs alleged violations, Bode consented to a 2 month suspension and a fine of $5,000

Herskovits PLLC has a nationwide practice defending against FINRA investigations and disciplinary proceedings. Feel free to call us for a consultation at 212-897-5410.

FINRA is on the look-out for violations of Rule 3280, which prohibits an FA from participating in a private securities transactions without giving written notice to the broker-dealer and receiving written approval. A “private securities transaction” is any securities transaction outside the scope of the FA’s employment with the broker-dealer. Private securities transactions remain a regulatory focus for FINRA. As noted by FINRAs CEO, Robert Cook, in the 2019 Risk Monitoring and Examination Priorities Letter: “we are particularly concerned about fundraising activities for entities that the associated persons control or in which they have an interest…”

Case In Point

In the Matter of Michael Jason Collins, FINRA Matter No. 2017056104801 (see the AWC itself)

Sanctions

• A 5 month suspension from association with any FINRA member in all capacities

• A fine of $10,000

Underlying Facts

Collins was terminated Robert W. Baird & Co. in October 2017. According to the Form U5 filed by the Firm, Collins was terminated because he “introduced [a] client to a private investment without Firm approval.”

According to FINRA, between February 2014 and December 2015, Collins participated in private securities transactions totaling approximately $200,000 without prior notice to Baird. Specifically, FINRA alleged that Collins solicited 15 individuals to invest in membership units of an LLC organized to operate a restaurant in Chicago. Although Baird approved Collins to invest in the LLC, the firm prohibited him from soliciting other investors. Nonetheless, FINRA found that Collins:

• Participated in the sale of membership interests
• Introduced investors to the restaurant’s business partners
• Discussed his own investment in the LLC with investors
• Attended networking events with the investors where the investment was discussed

Importantly, FINRA also found that 7 of the investors solicited by Collins were customers of Baird.

Analysis

The facts here make out a slam dunk case for FINRA. It certainly appears that Collins engaged in some serious no no’s. According to the facts presented by FINRA, Collins directly flouted his employer’s admonition not to solicit investments in the restaurant. To compound the problem, he apparently went to customers of the Firm to solicit investments. In so doing, Collins exposed Baird to litigation risk (it is possible that the customers thought the restaurant was a firm-sponsored investment, when it clearly wasn’t). Furthermore, by circumventing Baird’s system of supervision, he deprived Baird’s customers of the supervisory oversight they were entitled to.

FINRAs Sanction Guidelines provide guidance on proposed sanctions for selling away (private securities transactions). The Sanction Guidelines call for a monetary sanction of between $5,000 and $77,000, as well as a suspension of 10 days to 3 months for sales up to $100,000; 3 to 6 months for sales of $100,000 to $500,000; 6 to 12 months for sales of $500,000 to $1 million; and 12 months to a bar for sales over $1 million.

Given the facts of the case, Collins is fortunate that FINRA was willing to resolve the case within the sanction guidelines range.

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