The Financial Industry Regulatory Authority (“FINRA”) recently proposed and requested comment on new rules relating to FINRA membership as part of its ongoing effort to produce a consolidated rulebook.1 The proposed FINRA rules would adopt many provisions of the current NASD rules, while incorporating certain provisions of the NYSE membership rules. The proposed rules are intended to streamline the standards of review for new and continuing membership applications, clarify certain administrative aspects of the process, update or eliminate outdated terminology and require certain additional information about the applicant, including information as to business activities and control relationships with affiliates. Such information is intended to allow FINRA to assess an applicant more comprehensively within its overall organizational structure.
As part of its rule proposal, FINRA has proposed to add new defined terms, as well as expand the scope of current definitions contained within its rules. These proposed changes include the addition of definitions for “affiliate” and “control” which have not previously been defined under NASD or NYSE rules.2 The proposed changes are as follows:
- Affiliate - Proposed FINRA Rule 1111 would define the term “affiliate” to mean “(1) a person that directly or indirectly controls an applicant (excluding a natural person who controls an applicant solely in his or her role as a director, general partner, or officer (or occupies a similar status or performs a similar function)); or (2) an entity that is controlled by, or is under common control with, an applicant.”
- Control – Proposed FINRA Rule 1111 would define the term “control” as “the power to direct or cause the direction of the management or policies of a person whether through ownership of securities, by contract or otherwise.” Control would be presumed where another person directly or indirectly “(1) has the right to vote 25 percent or more of the voting securities; (2) is entitled to receive 25 percent or more of the net profits; or (3) is a director, general partner or officer (or occupies a similar status or performs similar functions) of the other person.
- ” Sales Practice Event – Proposed FINRA Rule 1111 would expand the definition of “Sales Practice Event” to include a “statutory disqualification” as defined under the Section 3(a)(39) of the Securities Exchange Act of 1934.
- Material Change in Business Operations – This term, which governs the events requiring firms to file a Continuance of Membership Application (“CMA”), has been expanded under proposed FINRA Rule 1160. Under this proposed rule a CMA would be required where a change “directly or indirectly” in the equity ownership, partnership capital “or other ownership interest” in a member results in one person directly or indirectly owning, controlling “or holding a presently exercisable option” to own or control 25 percent or more of the equity, partnership capital “or other ownership interest” in the member firm. The proposed rule also would include purchases or transfers or any divestitures of 25 percent of the assets of the member or any business line that produces 25 percent of the member’s earnings. The definition also would include instances where a member becomes self-clearing, clears for other broker-dealers or carries customer accounts for the first time or any change in exemptive status under SEC Rule 15c3-3.
These additions and changes are significant in the context of the more comprehensive review of a membership application proposed by FINRA, including an applicant’s relationship with its affiliates, as well as FINRA’s increasing emphasis on heightened transparency.
General Procedural Changes to the Membership Application Process
The proposed rules introduce minimal procedural changes to the Membership Application Process; however firms should be aware of certain timing changes which may affect their applications. First, proposed FINRA Rule 1112 decreases the time which an applicant has to respond to an initial written request by FINRA for information or documentation from 60 days to 30 days.
Second, under the proposed rules, absent a showing of good cause, an application will lapse if the applicant fails to schedule, within 30 days of filing its New Member Application (“NMA”) or CMA, all of the necessary qualification examinations for its associated persons. These examinations must be scheduled for (and completed by) a date not to exceed 120 days from the date the applicant filed its NMA.
Third, proposed FINRA Rule 1121 would require an applicant to file its Form NMA within 180 days of submitting its Form BD. If this period lapses without the required filing, FINRA would deem the application abandoned. Finally, interviews with respect to the membership process would be required to be scheduled within the later of 90 days of filing an application or 30 days of an additional information request made by FINRA.3
Expanded Information Requirements
Changes to Applicant’s Disclosure Requirements
Under Proposed FINRA Rule 1121, in addition to the requirements of former NASD Rule 1013, the new rule would require that new applicants provide information as to their affiliates, including an organizational chart identifying the applicant and all affiliates, with brief summaries describing each affiliate’s principal activity and the legal relationship between the applicant and its affiliate. Additionally, the applicant must submit a detailed, comprehensive summary of the business relationship between the applicant and any affiliate: (a) whose financial information is consolidated with the applicant; (b) whose liability or obligations have been either directly or indirectly guaranteed by the applicant; (c) that is the source of flow-through capital to the applicant; (d) who either the applicant or its customers rely on for operational support or services in connection with the applicant’s securities, investment banking or investment advisory business; (e) who has the ability to withdraw or cause the withdrawal of capital from the applicant; (f) who has a mutually dependant financial relationship with the applicant; or (g) who provides any third-party products and/or services as part of any operation or function of the applicant required to be supervised by the applicant under FINRA rules. Finally, the applicant must apprise FINRA of any plans to enter into contractual commitments, including, but not limited to, underwriting agreements and investment advisory agreements.
In addition to the required information concerning affiliates, proposed FINRA Rule 1121 creates additional disclosure requirements with respect to the applicant itself. These documents would include: establishing corporate documents (resolutions, by-laws, partnership agreements, etc.), anti-money laundering procedures, an organizational chart (including the identity of those individuals responsible for supervising each office, division and business line), and information concerning the independent audit firm (which must be PCAOB registered), the anticipated audit schedule and, if applicable, the most recent audit report.
The proposed rules also call for increased disclosure with respect to an applicant’s financials. Proposed FINRA Rule 1130 would add certain provisions to former NASD Rule 1014, including a new application evaluation standard that requires the applicant to fully disclose and document all of its funding sources in order to allow FINRA an opportunity to value their merits. Under the proposed rule, FINRA would have the authority to determine that a source of funding for an applicant is objectionable, and to use that as a basis to deny membership. This proposed rule also clarifies the need for member firms to maintain adequate financial and operational controls in order to comply with net capital requirements. This proposed rule would further expand the authority of FINRA to impose higher minimum net capital requirements on applicants with plans to enter into contractual commitments relating to underwriting or engaging in the investment advisory business (whether or not registered under the Investment Advisers Act of 1940).
The FINRA proposal also calls for procedural and substantive changes to requirements for current members who have a change in ownership or control. As noted above, proposed FINRA Rule 1160 would expand the criteria under which a CMA must be filed, including when a change “directly or indirectly” results in a change of control, or if there is a “purchase or transfer” of 25 percent or more of the member’s assets or any assets, business or line of operation that generates 25 percent of its earnings. The proposed rule would permit FINRA to waive a CMA where a change of ownership or control will not result in any practical change in the member’s business activities, management, supervision, assets, liabilities or ultimate ownership or control. Transactions where one or both of the parties are NYSE members, which are excluded from the filing requirements of current NASD Rule 1017, would no longer be excluded since NYSE Regulation no longer conducts reviews of such transactions.The current safe harbor provisions contained in current NASD IM 1011-1 would be retained in proposed Rule 1160, but Supplemental Material would explicitly exclude the availability of the safe harbor where the member or its associated persons have a “disciplinary history.” The proposed rule also provides for procedural and substantive amendments to the CMA process. Notably, it clarifies that an application that does not address all of the decision standards contained in proposed FINRA Rule 1130 would be deemed substantially incomplete. This proposed rule also would permit FINRA to impose interim restrictions on a member that effects a change in ownership or control pending final FINRA action on its application. Further, it contains new provisions clarifying the requirement that FINRA serve requests for additional information within 30 days of a complete CMA being filed, and allows an additional 30 days for a member’s response. Finally, under the proposed rule, the time frame for the Department of Member Regulation to issue a written decision on a CMA would increase from 30 to 45 days after the completion of the final CMA interview or a CMA applicant’s final filing of additional information, whichever is later.
With respect to amendments addressing the substance of CMAs, proposed FINRA Rule 1160 largely adopts the provisions of NASD Rule 1017; however, it additionally would require that CMAs and Membership Agreement Change applications identify and update any organizational information required under proposed FINRA Rule 1121(a) that has been rendered inaccurate as a result of the event triggering the application. The proposed rule also calls for the inclusion of a schedule and timeline for any systems changes and associated systems testing with the application.
Ongoing Disclosure Requirements
In addition to initial disclosure requirements for applicants seeking FINRA membership, the proposed FINRA rules also would expand disclosure requirements for current members and new members on an ongoing basis. Specifically, as noted above, proposed FINRA Rule 1111 would expand the definition of “Sales Practice Event” to include a “statutory disqualification” as defined under Section 3(a)(39) of the Securities Exchange Act of 1934. This inclusion would create an obligation for member firms to report the statutory disqualification of any of their employees or associates to FINRA on a timely basis through the CRD platform.
In addition to the expansion of events triggering a CMA, proposed FINRA Rule 1170 outlines certain significant events which would require prior written notice (30 days unless impracticable) to FINRA, even if such event does not require a CMA. These events are:
- The direct or indirect acquisition or divestiture of 10 percent or more in the aggregate of the member’s assets or any asset, business or line of operation that generates revenues comprising 10 percent or more in the aggregate of the member’s revenues;
- The direct or indirect acquisition or divestiture of 10 percent or more of the member’s shares, partnership interests or other ownership interest by any one person or control group;
- The addition, removal or subsequent modification of a business relationship between the member and an affiliate requiring disclosure under proposed FINRA Rule 1121;
- A change or loss of the member’s key personnel;
- A change in the member’s service bureau, clearance activities or method of bookkeeping or recordkeeping, or utilizing an outside service provider;
- The expansion of business requiring an infusion of capital that is 25 percent or more of the member firm’s net capital, or requiring additional licenses, registrations, memberships or approvals as required by a SRO or other regulatory agency;
- The expansion of business adding products or services that would be new in terms of the type of investments, transactions or risks from those business products or services offered by the member since the time of the last approval of a membership application;
- Increasing the number of sales personnel, office locations or markets made beyond the scope of the safe harbor provisions of proposed FINRA Rule 1160;
- The listing of the member firm on any facility or medium that is designed to solicit offers or inquiry with respect to the possible purchase of the member in whole or in part, or in the transfer of some or all of the member’s assets; or
- The discovery of any existing or impending conditions that the member reasonably believes could lead to capital, liquidity or operational problems, or the impairment of recordkeeping, clearance or control functions.
These proposals would result in a more thorough FINRA review of initial and continuing membership applications, and would involve greater disclosure of information involving a member’s relationship with its affiliates. While there would be better clarity of the process for such applications and more compressed time periods, broker-dealers should be aware of the expanded initial and ongoing disclosure requirements as to the operations of its affiliates, procedural changes to the application process, and expanded disclosure of statutory disqualifications and events that do not require a CMA, but are regarded by FINRA as being significant. While not specifically triggering a CMA, such events are likely to be subject to greater scrutiny prior to their commencement, which may delay the implementation of significant business decisions. Firms should discuss the potential effects of these proposed rules on their individual business with their legal counsel.