Financial Industry Regulatory Authority 3110
Supervision & Supervisory Control System
FINRA Rule 3110 regulates supervision and supervisory control systems.
This means firms are required to establish and maintain a system to oversee the activities of its associated persons that is designed to achieve compliance with the application securities laws and regulations as well as FINRA rules.
The content channels expected to be in compliance for FINRA Rule 3110 include: email, instant messaging, social media, text/SMS, audio, video, website and blogs. The regulated regions are North America and the United States.
For more compliance regulation rules, visit our Archiving Compliance Regulations & Supervision Rules page with all of the financial services regulations.
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* Erado assumes no liability for the accuracy or completeness of this information. Please consult with an attorney for information on specific rules and regulations and how they apply to your business.
FINRA Rule 3110 is the new supervision rule, of course, replacing old NASD Rule 3010. Most of it became effective on December 1, 2014, but, certain parts will only become effective on July 1, 2015. One of the latter sections is 3110(e), which addresses a firm’s obligation to investigate anyone being considered for registration, and anyone actually hired. It is important that BDs understand these obligations. Interestingly, the requirements outlined in Rule 3110(e) aren’t exactly new, as you will see. It’s just that FINRA has now incorporated the requirements in the rule itself.
Under existing FINRA rules, specifically, NASD Rule 3010(e) (which is still in effect until 3110(e) takes effect), before hiring anyone, and before filing a Form U-4, a broker-dealer is required to “ascertain by investigation the good character, business repute, qualifications, and experience of” the potential applicant. FINRA has specifically articulated only two things that a firm must do to meet that requirement. First, under 3010(e) itself, for any applicant who was previously registered in the securities industry, the firm must review the applicant’s most recent Form U-5. No big deal there, everyone does that, and they should be expected to.
|Second, according the boilerplate language buried in Form U-4, when the firm’s registered principal signs the form on behalf of a new applicant, he is attesting that the BD “has communicated with all of the applicant’s previous employers for the past three years and has documentation on file with the names of the persons contacted and the date of contact.” The attestation then continues: “In addition, I have taken appropriate steps to verify the accuracy and completeness of the information contained in and with this application.”|
The supposed protection provided by the requirement to “communicate with” prior employers has always struck me as a bit illusory, for a couple of reasons. First, in my experience, many firms are not even aware of this language in the form, and don’t actually contact former employers. Second, and more important, today, and for at least several years, most former employers will provide very little, if any, information about a former employee beyond that included on Form U-5, for fear of encountering claims of defamation or violation of privacy laws.)
Regardless, new FINRA Rule 3110(e) keeps the requirements of Rule 3010, but goes well beyond. While it parrots the language from NASD Rule 3010(e) that firms must still “ascertain by investigation the good character, qualifications and experience of an applicant” before registering the applicant, it now requires that within 30 days after Form U-4 is filed, that firms “verify the accuracy and completeness of the information contained in an applicant’s” Form U-4. Attentive readers will undoubtedly note that this is precisely the same language that currently appears in Form U-4. The issue for FINRA, the one that drove it to create Rule 3110(e), is that very few firms actually did the verification.
Next, and more important, Rule 3110(e) goes on to require – “at a minimum” – that firms must “search . . . reasonably available public records” to achieve that verification. Thus, in essence, with its Rule 3110(e), FINRA has tried to take the mystery out of the phrase “appropriate steps to verify” in Form U-4 by defining that to mean a public record search.
This development is troubling for several reasons. First, it is evident that FINRA will now require two separate investigations, one pre-filing of Form U-4 and one post-filing. It is difficult to understand why FINRA has taken this approach. I mean, why not roll the two requirements up together into a single, pre-hire policy? And what, really, is the difference between the two anyway?
Second, who knows what “reasonably available” means, or what, more importantly, it will be interpreted by FINRA to mean? Who will determine how far back in time a search must go? Question 12 on Form U-4, for instance, requires an applicant to list his previous employers for ten years, and Question 11 asks for prior residential addresses for five years. How is a firm supposed to “verify” the accuracy and completeness of such information? Will it be enough to hire a competent third-party vendor? Or will FINRA scrutinize the vendor’s search protocols?
Third, it flips on its head the ability of a firm to rely on representations made to it by an applicant. When someone signs a U-4 to apply for registration, he already “swear[s] or affirm[s] that . . . [his] answers (including attachments) are true and complete to the best of [his] knowledge.” The applicant’s signature also acknowledges that he “understand[s] that [he is] subject to administrative, civil or criminal penalties if [he] give[s] false or misleading answers.” If the information is not complete and accurate, the applicant has opened himself up to disciplinary action. (And, as discussed in another entry in this Blog, if the failure to disclose is deemed to be willful, he also renders himself statutorily disqualified.)
There are many instances in the course of a typical day or year in which a BD has to rely on its registered persons to make complete and accurate representations, and historically that has been deemed to satisfy the requirement that supervisory systems only be “reasonable.” Yet, here, reliance by a BD on an applicant’s representations on Form U-4 is somehow not reasonable, despite the significant pressure on the applicant to ensure that those representations are correct. And this is a troubling direction for FINRA to be going. Will BDs soon have to verify the accuracy and completeness of the information that customers provide about their financial circumstances?
When FINRA asks to speak to your Supervisor…
FINRA requires all broker-dealers to have a supervisory framework in place that is “reasonably designed” to comply with applicable rules and regulations.
Challenges arise when a FINRA member attempts to supervise itself, including conflicts of interest and completing the Rule 3120 report, which are difficult to overcome without assistance.
Overview & Purpose of the Supervisory Framework
The Financial Industry Regulatory Authority, Inc. (“FINRA”) Rules 3110, 3120 and 3130, together, mandate that all broker-dealers establish and maintain supervisory procedures appropriate for the member’s business, size, structure and customers. Specifically, each of the aforementioned FINRA Rules act as an element of a supervisory framework designed to ensure that member firms have procedures and controls in place which adequately address applicable rules, regulations and internal policies. This article will address each of these Rules in turn.
FINRA Rule 3110 lays the initial framework for self-supervision. More precisely, Rule 3110(a) requires members to have a supervisory system and written supervisory procedures that are reasonably designed to achieve compliance with applicable securities laws and regulations. This supervisory arrangement must be “reasonably designed” to comply with FINRA’s qualification requirements for persons acting in a supervisory capacity. In addition, Rule 3110(b)(6) requires controls to address the conflicts of interest of the associated person being supervised, such as the supervised person’s position, the amount of revenue such person generates for the firm or any compensation that the supervisor may derive from the associated person being supervised.
Rule 3110(b)(6) also prohibits supervisory personnel from overseeing their own activities, and reporting to, or having their compensation or continued employment determined by, a person or persons that they are supervising. As an exception to this prohibition, Rule 3110(b)(6)(C) permits a firm to allow this conflict if it determines that compliance is not possible because of the firm’s size or a supervisory personnel’s position within the firm. Each member firm must document the factors used to reach its determination, and how the supervisory arrangement (with respect to such supervisory personnel) complies with the Rule. In sum, the supervisory framework must be reasonably designed by the broker-dealer to supervise its employees’ conduct, while avoiding conflicts of interest
A high level overview of the supervisory rules and their takeaways are described in the below table.
Report of Findings at the Broker-Dealer
FINRA Rule 3120 mandates documentation and reporting on the member firms’ supervisory framework. Under Rule 3120, member firms are required to create additional or amend supervisory procedures where the need is identified by such testing and verification. In addition, the designated principals must submit to the firm’s senior management, no less than annually, (1) a report detailing the firm's system of supervisory controls; and (2) a summary of the test results and significant identified exceptions, as well as any additional or amended supervisory procedures that have been created in response to those test results. Specifically, the report identifies the processes a firm follows to establish, maintain, review, test and modify its written compliance policies and written supervisory procedures.
This report must be also be submitted to the member's board of directors and audit committee (or equivalent bodies) in final form either prior to execution of the certification, or at the earlier of either their next scheduled meetings or within 45 days of the date of execution of the certification.
FINRA Rule 3130 requires member firms to establish the tone at the top. To do this, Rule 3130 requires members’ C-Suite personnel (i.e., CEO) to certify that the report adequately documents the member’s processes for establishing, maintaining, reviewing, testing and modifying compliance policies, which are reasonably designed to achieve compliance with applicable federal securities laws and regulations, including FINRA and MSRB rules.
Approach for Compliance
Although FINRA lays out the requirements for establishing a supervisory framework, there are operational implications of compliance. First, member firms must independently identify the business activities that fall within the applicable rules, regulations and internal controls for each activity, as well as the associated persons that have supervisory responsibilities, and review the effectiveness of the firm’s supervision over these activities. Second, conflicts of interest must be identified, which could be difficult without performing an independent assessment. Third, member firms must ensure that they are capable for independently analyzing and testing of current supervisory procedures to determine if those procedures adequately address applicable rules, and establish new, or revise existing, supervisory procedures where deficiencies are noted.
An independent firm can assist member firms with navigation of these operational challenges by completing independent review and/or audits, and testing the member firm’s supervisory control procedures and supervisory system to determine where the firm may be at risk. The findings delivered by an independent assessor should be included in the Rule 3120 report that will detail the supervisory review, and also provide recommendations that will improve the broker-dealer’s compliance and operational controls. In addition, an independent firm can provide all firm personnel under supervision specialized training that addresses regulatory needs, including, but not limited to, anti-money laundering, asset and liability management, customer complaints, detecting and reporting customer complaints, and personnel supervision.
Broker-dealers are required by FINRA to have a supervisory framework in place that adequately address all applicable rules and regulations, depending on the size of the member firm. Member firms must ensure that not only their policies and procedures account for identifying issues, but that all gaps are properly documented and reported. Navigating these requirements while avoiding conflicts of interest can be challenging, and an independent firm may be in a better position to readily analyze and test supervisory procedures.
Broker-dealers must annually submit the following:
A report to the firm’s senior management that details the firm's system of supervisory controls.
Summary of the test results and significant identified exceptions, and any additional or amended supervisory procedures that have been created in response to those test results.
An independent assessment can assist with this report, and provide training and expertise to satisfy all applicable regulations.
FINRA Rule 3110(b)(4) requires firms to have supervisory procedures in place to review incoming and outgoing written (including electronic) correspondence and internal communications relating to its investment banking or securities business. Firms must review:
(1) Incoming and outgoing written correspondence to identify and handle customer complaints, instructions, funds and securities and communications whose subject matter requires review under FINRA rules and federal securities laws; and
(2) Internal communications to identify communications of subject matter requiring review under FINRA rules and federal securities laws.
Review of these correspondences and communications must be conducted by a registered principal and evidenced in either electronic or paper writing.
Link to Rule: http://finra.complinet.com/en/display/display_main.html?rbid=2403&element_id=11345
Helpful Link: http://finra.complinet.com/en/display/display.html?rbid=2403&element_id=11470
The Securities and Exchange Commission (“SEC”) has recently approved the Financial Industry Regulatory Authority’s (“FINRA’s”) proposed new consolidated rules for Supervision and Supervisory Control Systems. These FINRA rules – issued as Rules 3110, 3120, 3150, and 3170, to replace regulatory Rules 3010, 3012, and 3110(i) go into effect on December 1, 2014.
One of these areas, the new FINRA Rule 3110 which governs Supervision, is perhaps the most complex. The Rule is broken down into five (5) key sub-sections:
3110(a) is focused on establishing a set of minimum requirements that a firm must follow in its required Supervisory System for its associated personnel and includes: establishing/maintaining written procedures; designating and qualifying principals and offices of supervisory jurisdiction (“OSJ”); designating OSJ and Non-OSJ branch principals; establishing supervisory procedures for OSJ principals, including One-Person OSJs; and participating in an annual compliance meeting.
3110(b) which is based on NASD 3010(b), further defines the making and maintenance of Written Procedures for supervising business and personnel actions. This includes: investment banking transaction review through a risk-based system; supervisory procedures and risk-based review for incoming and outgoing business communications, with evidence, delegation and retention of review and correspondence as requirements; customer complaint reviews; and supervision of supervisory personnel.
3110(c) concentrates on the need for firms to inspect and review their business engagements, with requirements such as: mandatory inspection cycles; requirements for inspection reports; requirements for associated individuals who conduct inspections; and defining of conflicts of interest.
3110(d) requires a supervisory process for reviewing securities transactions with the aim to more readily identify trades that violate Exchange Act provisions or FINRA rules on insider trading. This includes identifying violative trades on covered accounts and performing internal investigation reporting.
3110(e) is maintaining the NASD Rule 3010(g) definitions of a “branch office,” an “office of supervisory jurisdiction (OSJ)” and “business day.”
In next week’s blog post, CCLS will further review new FINRA Consolidated Supervision Rules, including Rules 3120, 3150 and 3170.
For further information on this and other related subjects, please contact us at (619) 278-0020.
GENERAL DISCLAIMER: Information contained within this blog does not create a business-client relationship, and none of the content of this blog can be deemed to be consultive business advice.
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