RIA Compliance and Practice Management Blog

FINRA Proposes New Rule on Outside Independent RIA Supervision

Posted by RIA in a Box

Feb 28, 2018 4:28:11 PM

FINRA requirement to supervise outside RIA activity rule changeOn February 26, 2018, the Financial Industry Regulatory Authority ("FINRA") released a new rule proposal, that if passed, would streamline a broker dealer's supervision requirements related to registered representatives operating as part of independent, third-party registered investment adviser ("RIA") firms. While FINRA does not presently regulate investment advisory firms, FINRA Rule 3280 and related guidance has required broker dealers to "supervise and record on the members’ books and records the transactions resulting from most outside investment adviser ("IA") activities of their associated persons." Today, this outside activity supervision requirement has been interpreted a number of different ways and has often led to significant confusion and contention in the independent broker dealer world as to what is exactly required. 


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Proposed Changes to FINRA's Independent RIA Supervision Requirements

As it relates to independent investment adviser activity for an individual that is dually registered with an independent broker dealer and independent RIA firm, FINRA notes the following (bold added for emphasis):

The proposed rule would impose a supervisory obligation in two situations. First, if a member imposes conditions or limitations on a registered person’s participation in an investment-related activity, the member would be required to reasonably supervise the registered person’s compliance with those conditions or limitations. The proposed rule would not require members to supervise the underlying activities. For example, after conducting the required risk assessment of an investment-related activity, a member may approve a registered person to act as a registered investment adviser through an unaffiliated, third-party IA; however, the member also may condition that approval on the IA’s custody of its clients’ advisory assets with the member. In this example, the proposed rule would require the member to reasonably supervise the registered person’s adherence to that condition, but the member would not be required by the rule to otherwise supervise the IA activity.

Why FINRA May Change the Requirement to Supervise Outside Investment Adviser Activity

In particular, FINRA regulatory notice 18-08 notes the following in regards to supervision of outside investment adviser activity (bold added for emphasis):

The proposed rule would change the current approach with respect to IA activities of registered persons. Under Rule 3280 and related guidance, members must supervise and record on the members’ books and records the transactions resulting from most outside IA activities of their associated persons. This approach has caused significant confusion and practical challenges, including, for example, privacy challenges with a member obtaining account information for customers of an unaffiliated IA through which a member’s registered person may be acting in an IA capacity. Given these challenges, and in light of the fact that these activities are subject to another regulatory regime, some stakeholders argued that the current approach imposes unnecessary burdens without providing meaningful investor protections over the activities.

Based on FINRA’s review of the rules, public comment and other stakeholder feedback, and the evolving environment in which members operate, modifications to the current approach appear appropriate. Under the proposed rule, as discussed above, any IA activity conducted on behalf of a dually registered BD/IA or for an IA affiliate of a member would be excluded from the rule. Any IA activity conducted for a third-party, non-affiliated IA would constitute an “investment-related” activity under the rule. As such, the rule would require that the registered person provide prior written notice of such activity, and the member would be required to conduct the upfront risk assessment described above and, based on its assessment, to approve the registered person’s participation, to approve it subject to conditions or limitations or to disapprove it. However, the proposed rule would not impose a general supervisory obligation over the IA activities and would not require the member to record on its books and records transactions resulting from such IA activities. Although this proposed approach streamlines members’ obligations over IA activities, these IA activities would continue to be subject to regulatory oversight by the SEC and states under a different regulatory scheme.

What Comes Next as it Relates to Broker Dealer Supervision of Independent RIA Activity

The current comment period for this proposed rule change ends on April 27, 2018. If the new proposal moves forward, it is likely to replace current FINRA Rule 3270 (Outside Business Activities of Registered Persons) and FINRA Rule 3280 (Private Securities Transactions of an Associated Person). However, it is important to note that FINRA is still seeking feedback about potential alternatives to this current proposed rule change. However, FINRA does highlight that this rule proposal was driven by previous feedback which pointed to a "rules-based approach with specific requirements" rather than a "principles-based approach."

It's unclear when this proposed rule change may become effective should it continue to proceed. However, it could lead to significant changes to how independent broker dealers currently interact with dually-registered representatives that operate their own independent RIA firm. Historically, many broker dealer firms have charged additional fees to cover outside business activity supervision requirements as currently mandated by FINRA. This additional fees have often been a point of a contention in the industry and it's possible this potential regulatory change could reduce if not eliminate such fees from the equation leading to further fee pressure on the independent broker dealer business model.

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Lexington Compliance and RIA in a Box LLC are not law firms, investment advisory firms, or CPA firms. Lexington Compliance and RIA in a Box LLC do not provide legal advice or opinions to any party or client. You should always consult your relevant regulatory authorities or legal counsel if applicable.

Topics: RIA Compliance, RIA Operations

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