In Regulatory Notice 17-38 (Regulatory Notice),1 the Financial Industry Regulatory Authority (FINRA) requests comments on a proposal (Proposal) to amend FINRA’s Conduct Rule 3110 (Supervision). The Proposal would add new Supplementary Material .15 (Remote Inspections), which would afford FINRA member firms (firms) the option to conduct remote inspections of their “qualifying offices,” rather than through physical, on-site inspections. The Proposal is intended “to reduce the burden of on-site inspections in limited circumstances that would not result in a diminution in investor protection.”
The Regulatory Notice indicates that the Proposal is a response to firms’ questions regarding how to conduct internal inspections in a cost-efficient manner, as technological changes have led to more flexible work arrangements. To utilize remote inspections of its branch offices, the Proposal would require a firm to have procedures reasonably designed to determine whether such offices meet the criteria for a “qualifying office,” and to assess whether a remote inspection of a qualifying office is reasonable.2 The Proposal also defines the specified criteria for a qualifying office, as described below.3
Comments on the Proposal are due by January 12, 2018. If authorized by FINRA’s Board of Governors, the Proposal will subsequently be filed with the Securities and Exchange Commission for approval following public comment.
Rule 3110 sets forth supervisory requirements for firms, including the establishment and maintenance of a supervisory system, implementation of written procedures, and conducting (at least annual) internal inspections. FINRA interprets the Rule to require firms to conduct on-site inspections of their office locations to fulfill their supervisory obligations.4 Currently, on-site inspections are required even for remote offices where limited firm activity takes place. According to FINRA, firms have questioned the efficiency and practicality of conducting on-site inspections of remote offices with few associated persons, or where the office’s activities involve only operational or limited supervisory functions. The Regulatory Notice indicates that firms have cited “travel and related expenses incurred in connection with on-site inspections of these low-risk locations and have suggested that these resources could be better allocated to higher risk activities.” In response to these concerns, FINRA is proposing to adopt Supplementary Material .15 (Remote Inspections) to Rule 3110, which would permit firms to conduct remote inspections of a qualifying office, rather than an on-site inspection of such office.
“Qualifying Office” Criteria
Proposed Supplementary Material .15 sets forth the conditions that must be satisfied in order to be eligible as a qualifying office:
No more than three associated persons are designated to the location;
The location is not publicly represented as a firm office;
Associated persons at the location conduct firm business only through the firm’s authorized electronic systems and platforms;
Books and records maintained to comply with FINRA rules and federal securities laws are maintained other than at that location;
The location does not handle any customer funds or securities;
The location: (i) is not required to be inspected annually; (ii) is designated as an Office of Supervisory Jurisdiction (OSJ) solely due to specified supervisory activities;5 or (iii) is designated as a branch office solely because it supervises associated persons’ activities at one or more non-branch locations; and
The location does not have any registered persons with a disciplinary history or subject to a statutory disqualification.
The Proposal would require a firm that conducts remote inspections of its offices to have procedures reasonably designed to determine whether the office is eligible as a qualifying office and to ensure that the office remains compliant with the qualifying office criteria. The Supplementary Material would also require a firm to assess whether a remote inspection of a qualifying office is reasonable. Consistent with existing requirements for supervising offices, in assessing whether a remote inspection of a particular office is reasonable, a firm would be required to consider the “firm’s size, organizational structure, scope of business activities, number and location of the firm’s offices, the nature and complexity of the products and services offered by the firm, the volume of business done, the number of associate persons, and any indicators or irregularities of misconduct (i.e., “red flags”).”6 In addition, the firm would be required to consider whether any associated person at the designated office has a record of any investment-related civil complaints that is disclosed, or should have been disclosed, in Items 14C through 14J of that person’s Form U4.
Accordingly, as with on-site inspections, a firm seeking to use off-site inspections of remote offices would need an inspection program that is “reasonably designed to assist the firm in detecting and preventing violations of, and achieving compliance with, applicable securities laws and regulations, and with applicable FINRA rules. As with on-site inspections, remote inspection reports would be required to be written and kept on file for the periods of time specified for the relevant inspection cycle.”
The Regulatory Notice indicates that FINRA “considered a range of suggestions in developing the Proposal.” Alternatives to the proposed Supplementary Material included a different maximum number of associated persons in the qualifying office criteria, and a different definition of associated person misconduct.
Specific Requests for Comment
In addition to requesting comments with respect to the Proposal generally, FINRA is seeking comment on the following specific issues:
- How conducting remote inspections would impact a firm’s current inspection process;
- Whether a firm with a history of disciplinary violations should be able to conduct remote inspections;
- What other criteria might be considered for a qualifying office determination – for example: a volume of business threshold; a minimum distance between the qualifying office and the OSJ or supervisory branch office; requiring on-site inspection of an office prior to its designation as a qualifying office; and requiring interviews with associated persons designated to a qualifying office;
- What might be a reasonable limitation on the number of associated persons designated to a qualifying office;
- Whether any criteria should be excluded from a qualifying office determination;
- Whether the Proposal might impede a firm’s ability to meet its supervisory duties under Rule 3110; and
- Potential material economic impacts of the Proposal, including upon investors, issuers and firms.