In March 2015, FINRA issued Regulatory Notice 15-07,14 which describes FINRA’s upcoming rule changes relating to payments by FINRA member firms to non-members. The rule changes will be effective on August 24, 2015. These provisions may be of particular interest to broker-dealers that offer structured products; during the last several years, U.S. structured products distributors have engaged a variety of non-member U.S. and foreign firms to assist in promoting broader sales of these products, typically in exchange for transaction-based compensation.
FINRA Rule 2040(a) and Unregistered Persons
Rule 2040 governs transaction-based payments by FINRA members to unregistered persons. As amended, Rule 2040 will effectively “incorporate by reference” the provisions of Section 15(a) of the 1934 Act and the related guidance under that statute to determine whether an entity can receive transaction-related compensation. Rule 2040(a) will prohibit FINRA members from paying transaction-based payments to any person that is not a registered broker dealer under Section 15(a), but, due to the receipt of the payment and its related activities, is in fact required to be so registered.
How will a FINRA member determine whether a proposed recipient of a payment is required to register under Section 15(a)? For this purpose, FINRA adopted supplemental materials, which enumerate several non-exclusive ways in which a FINRA member can make this determination about another party:
- reasonably relying on previously published releases, no-action letters, or interpretations from the 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.
Of course, in many cases, the determination of whether a party must register under Section 15(a) is fact-specific and requires careful assessment of the party’s activities.15 Accordingly, FINRA members will want to perform significant due diligence in connection with relying on the first bullet above. As to the second bullet above, obtaining a no-action letter from the SEC is likely to be time-consuming and possibly somewhat expensive. The third option above is likely to be most useful where the relevant third party is represented by qualified U.S. counsel that understands its business and is capable of providing this type of legal opinion on a relatively short timeframe.
Needless to say, the nature of an entity’s business may vary over time. As a result, in its supplemental material, FINRA encourages members to review their determination periodically if the relevant payments are ongoing in nature. FINRA expects members to maintain books and records that reflect the determinations that are made.
Rule 2040(c) and Non-registered Foreign Finders
New Rule 2040(c) is designed to spell out the circumstances under which a FINRA member can pay transaction-related compensation to a non-registered foreign finder. This question can arise in the structured products area when a non-U.S. broker, fund manager, or other entity offers a U.S. broker to refer a client, typically in exchange for a percentage of the offering proceeds. Rule 2040(c) sets forth a relatively detailed set of requirements for these types of payments to be made, including:
- the FINRA member must assure itself that the finder is not required to register in the United States as a broker- dealer (or is subject to a disqualification as defined in Article III, Section 4 of FINRA’s By-Laws16), and must assure itself that the compensation arrangement does not violate applicable foreign law;
- the finder must be a non-U.S. national or a non-U.S. entity that is domiciled outside of the United States;
- the customers to whom the securities are sold must be non-U.S. nationals or non-U.S. entities domiciled outside of the United States;
- the customers must receive a descriptive document that discloses the compensation that is being paid to finders;
- the customers must provide written acknowledgement to the FINRA member of the existence of the compensation arrangement; and
- the confirmation of each transaction indicates that a referral or finder’s fee is being paid.
Several of these requirements may be difficult to satisfy rapidly. As a result, and for these foreign finders as well, it may be useful to have an appropriate internal lawyer or available external counsel who can quickly confirm to any interested FINRA members that the entity is not subject to registration as a broker-dealer.