Earlier last week, the Financial Services Institute (FSI) released its white paper on outside business activities (OBAs). FSI’s release is timely as the Financial Industry Regulatory Authority currently is reviewing its OBA rule as part of its retrospective rule review process.
“By leveraging the insight of our members and applying the extensive experience of our partners,” says FSI President & CEO Dale Brown, “we can provide actionable common and innovative practices to help our members respond to common issues and pitfalls…while also ensuring compliance.”
The whitepaper, written in conjunction with Eversheds Sutherland (US) LLP and members of the FSI Compliance and Investment Advisory Services Councils, found that OBAs take a variety of forms and have a particular place in serving the needs of clients drawn from rural, or sparsely-populated areas. It also discussed compliance with FINRA and state regulatory requirements, and potential exposures for non-compliance.
Outside business activities deliver one-stop shopping
According to the FSI whitepaper, the independent broker-dealer channel, which historically provides services to “main street USA” in less populous or affluent communities, are more likely to engage in outside business activities. Frequently, the only financial experts in their community, their clients often request and rely on their financial advisor for such additional services as insurance, accounting or other financial-related expertise that are outside the typical scope of the advisor’s securities license.
Regulators worry about the impact of OBAs on broker-dealer decision-making regarding OBA approvals and a firm’s efforts to monitor their advisors’ activities.
Activities not without issues
FINRA and state enforcement actions are just one indication that OBAs can have consequences when advisors fail to report an OBA or a firm is less than rigorous in approving or adequately monitoring approved OBAs. Most frequent issues include:
- Advisors using their OBA to engage in selling away; or
- Investor confusion when they do not understand that they are dealing with the financial advisor outside of his/her relationship with the firm and may assume the OBA business includes the same obligations and protections as the business they conduct through the firm.
What can be confusing is that OBAs include so many non-securities business activities which are conducted outside the scope of the relationship a financial advisor has with their broker-dealer firm. Activities for which advisors may be compensated may include fixed insurance sales, operating a registered investment adviser or providing additional services such as tax preparation, accounting support, bookkeeping or legal advice. Compensation-less OBAs might include unpaid non-compensated leadership positions such as being a president, treasurer, trustee or other position on a non-profit board of trustees.
Identifying OBAs says the FSI study, is the first step toward compliance.
FINRA Rule 3270 restricts a financial advisor’s ability to engage in OBAs, and most independent broker-dealer (IBD) firms have written supervisory procedures requiring financial advisors to inform them of their OBA and to stop practicing them until their firm approves or disapproves them.
Once informed, the IBD firm must determine whether the OBA is:
- Permitted per the firm’s written supervisory procedures;
- Approved by the firm per their written supervisory procedures, but subject to specific conditions; or
- Not permissible per the firm’s written supervisory procedures resulting in the financial advisor barred by the firm from engaging in it under any circumstances.
Once an OBA is approved, the regulators expect ongoing OBA monitoring for compliance with any limitations. But as regular readers of our blog, you know all that…right?
FINRA Rule 3110 requires firms to adopt written supervisory procedures reasonably designed to ensure compliance. This includes adequately outlining the OBA approval process, documentation, and monitoring. Firms must document and preserve for example a written:
- Summary of the activities to be performed by the financial advisor;
- Request from the financial advisor to engage in the outside business activity; and
- Response from the firm acknowledging the request and approving, limiting or denying the advisor’s involvement with that activity.
Non-compliance is co$tly
Failure to comply with FINRA Rule 3270 can result in monetary sanctions of $2,500 to $73,000. How much you’ll pay depends on:
- Whether the OBA involved firm clients;
- Whether it resulted directly or indirectly in injury to clients of the firm and, if so, the nature and extent of the injury;
- The duration of the outside activity, the number of clients and the dollar volume of sales;
- Whether the respondent’s marketing and sale of the product or service could have created the impression that the firm had approved the product or service;
- Whether the respondent misled his or her firm about the existence of the outside activity or otherwise concealed the activity from the firm
- The importance of the role played by the respondent in the OBA.
The FSI whitepaper also recommends asking:
- Will the OBA confuse the client?
- Will it be confused with the broker-dealer business?
- Is the OBA actually a PST?
- Where will the OBA take place?
- Will the OBA be covered under the firm’s E&O insurance?
- How often will the firm review this activity?
- What sort of due diligence will the firm have to take in order to monitor potential changes in the activity?
- Even if the role is an unpaid volunteer role, are the facts and circumstances such that the firm should be concerned about the activity?
- Even if there is no compensation, does the expectation of compensation exist or might it exist in the future?
- Does the role, whether paid or unpaid, involve access to funds (for example, a treasurer role)?
- How might the OBA change over time? For instance, could it evolve into a paying position, could it begin to require a larger time commitment, is there a possibility of PSTs going through the OBA, etc?
- Could the OBA be confused as being offered through the firm?
FSI also suggests monitoring:
- When an advisor sets up an LLC or other partnership or corporation, are the other named principals firm clients;
- Lifestyle changes that do not fall in line with the advisor’s earnings and investigate those changes by reviewing the advisor’s tax records – even occasionally looking at Zillow to see the value of an advisor’s home to ensure they are living within their means;
- An advisor’s third party emails that come through the firm’s server; and
- Periodically re-evaluating approved and denied activities, and confirming that the advisor is not secretly engaging in any denied OBAs.
FINRA red flags
The FSI whitepaper identified the following issues that will pique regulatory interest:
- Incorrectly treating conduct as an OBA instead of a private securities transaction (PST).
- Failing to supervise for compliance with FINRA Rule 3280. FINRA has sanctioned firms for treating PSTs as OBAs. In one case the report mentioned, a firm conducted an examination of the office of one of its financial advisors and discovered that the representative was recommending “managed accounts” and “alternative investments” through his outside registered investment advisor (RIA), even though he had never disclosed this business to his firm. Later in the year, the same financial advisor disclosed to his firm that he was managing an investment fund as an OBA. FINRA found that the firm failed to adequately investigate these red flags, therefore failing to identify his participation in PSTs. Worse yet, FINRA found that this same firm also failed to identify the failure to supervise the PSTs of 79 additional financial advisors registered with the firm because the firm treated their representatives’ trading activities as OBAs rather than PSTs. Because FINRA determined that the firm failed to establish and maintain a reasonable supervisory system, it fined the firm $500,000 for this and other violations.
- Failure to properly investigate red flags indicating a likely PST or fraud. FINRA has sanctioned firms for failing to properly investigate red flags regarding OBAs, including in one case, sanctioning a firm and its CCO for failing to follow up an OBA disclosure red flag when a financial advisor disclosed forming an OBA for the purpose of “raising capital for investment in closely held businesses.” The advisor reported that he served as a “managing member coordinating structure and bringing investors.” FINRA found that CCO approved and failed to review the OBA, and fined the firm $70,000, suspended the CCO from acting in a principal capacity for six months and fined him personally $5,000.
- Failure to disclose OBAs on Forms U4. The FSI paper reported that FINRA fined one firm $500,000 for failing to file Form U4 amendments after its representatives had properly disclosed their OBAs and then also failed to file Form U4 amendments for more than 4 months after FINRA notified the firm of its deficiencies.
- Failure to enforce WSPs. A firm’s WSPs require all supervising principals to “poll all the individuals under their direct supervision to determine if any amendments [were] required on their U4 to either report a new disclosure event or to change the status of a currently disclosed event” on a monthly basis.
- Failure to have written supervisory procedures (WSPs) addressing FINRA Rule 3270. In one instance cited in the FSI whitepaper, FINRA fined a firm $200,000, suspended the CEO/CCO for two years and fined him $25,000 for failing to monitor representatives’ outside business activities because the firm did not revise the firm’s policies to make them consistent with the revised rule. Moreover, while the firm was notified of proposals to engage in certain OBAs, it failed to review them for compliance.
Despite budget cuts, financial industry regulatory bodies are still intent on keeping an eye out for compliance errors and omissions (or outright wrongdoing!). They will continue to scout out bad actors acting badly. So you should still be prepared. Noncompliance can be costly, but you can access compliance solutions that won’t break the bank.
Let’s talk (212-233-1155). Ask about Patrina’s comprehensive compliance solutions and compliant data capture, file storage, and records archiving specifically designed for the financial services community. We’ve got you covered.