On August 24, 2015, the SEC implemented FINRA Rule 2040. This rule is related to whether and how people who are not registered as broker-dealers can receive compensation that derives from financial transactions.
More specifically:
Rule 2040(a) prohibits member firms or associated persons from, directly or indirectly, paying any compensation, fees, concessions, discounts, commissions, or other allowances to:
“(1) any person that is not registered as a broker-dealer under SEA Section 15(a) 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.
This essentially means that anyone receiving compensation from a transaction must first check with SEC rules to determine whether or not that would obligate them to be formally registered as a broker-dealer. Furthermore, the rule requires that people who are appropriately registered comply with all applicable federal securities laws.
Payments to Unregistered Persons
FINRA is the Financial Industry Regulatory, and it now prohibits firms and their related associates from compensating parties to financial transactions who are not registered as broker-dealers. If it does, it will have to provide evidence of “reasonable support” for its determination that the person in question did not have to be registered. According to the Rule, this can be demonstrated in the following ways:
- Reasonably relying on previously published releases, no-action letters or interpretations from the SEC or SEC staff that apply to their facts and circumstances;
- Seeking a no-action letter from the SEC staff; or
- Obtaining a legal opinion from independent, reputable U.S.-licensed counsel knowledgeable in the area.
The Status of the Broker-Dealer and Registered Representatives
While the three options listed above are strictly regarded, they are not exclusive. Member firms can rely on outside counsel to make their reasonable determinations. Other liberties lie in the fact that the Exchange Act does not directly address the question of compensation for broker-dealers, instead of treating financial actors as either brokers — who engage in the business of effecting transactions in securities for the account of others — or dealers — who engage in the business of buying and selling securities for its own account.
Both must register with the SEC for interstate commerce purposes. But the courts and the SEC have used a “facts and circumstances” standard to make their own determinations about what role the agent is serving. Compensation is a hallmark of broker and dealer activities, but the SEC and the courts have historically differed in their perspectives.
The SEC places a strict burden of proof for financial agents to demonstrate that they are not required to register as a broker-dealer. The courts, on the other hand, are less likely to hold such a firm line. Regardless of where they fall on that question, there are still some common exceptions that both observe. They include:
- Certain types of foreign broker-dealers or finders
- Certain types of merger and acquisition advisers
- Ordinary dividend payments to the broker-dealer’s shareholders
- Payments to an affiliate that allows them to serve as the “paymaster” for employees of their group
- Soft dollar commission payments to researchers
The rule also allows retired members of FINRA-compliant firms to receive compensation.
Although these exceptions exist, they cannot readily be extended to apply to situations beyond those terms. Each is subject to narrow and specific conditions that allow them to be permitted.
What Are the Applicable Federal Securities Laws?
To better understand FINRA Rule 2040, it is helpful to run through a quick history lesson. Action by FINRA (and the preceding financial institutions) governing fees and compensation related to securities transactions are not at all new — but they did need to be updated.
The original concept motivating these kinds of rules was to promote membership in FINRA by discouraging members from working with firms and agents who were not members. That eventually became irrelevant, as overtime almost all broker-dealers have been required to become members, leading to a shift in interpretation that focused on preventing members from working with broker-dealers who were not registered with the SEC.
The Securities and Exchange Act of 1934 required all broker-dealers to register with the SEC. But there naturally emerged some key exceptions (outlined above) for whom it made sense to allow operating privileges despite the existing regulations. FINRA Rule 2040 codifies their long-standing interpretation of the situation into law. In the process it replaces or modernizes:
- NASD Rule 2420
- NYSE Rule 353
- NYSE Rule 345(a)
Taken together, FINRA Rule 2040 provides firms with the ability to conduct transaction-based compensation with greater clarity around who must be registered with the SEC, and under what conditions they can work with people who are not. It also provides “reasonable support” standards to help ensure that compensation to registered and unregistered broker-dealers alike is legitimate.
Conclusions About FINRA Rule 2040
In theory, all of this is relatively straightforward. But in practice, it can be much more complex. One of the biggest challenges is secretarial in nature: it is quite simply difficult to track down all of the relevant materials. Items like no-action letters from SEC staff, rules releases, and other obscure documents, requiring those who need them to consult several resources on the SEC website, including:
- Guide to Broker/Dealer Registration;
- Exchange Act Rule 15a-6 and the related adopting release, which address the cross-border application of the B/D registration requirements;
- Exchange Act Release 34-46745 (Oct. 30, 2002), which proposed certain exemptions for banks from the B/D registration requirements; and
- Selected no-action letters concerning B/D registration requirements
Without lots of experience with this type of work, it can quickly turn into a quagmire of a project that threatens to undermine the legitimacy of your firm’s transaction-based compensation practices.
Succession Resource Group can lend you that experience. With decades of professional expertise to draw from, our team can help guide you through the ins and outs of FINRA Rule 2040. Contact us today for a consultation so you can rest easy knowing you have met your compliance obligations.
