It is a simple fact that a broker-dealer has no obligation to supervise a disclosed outside business activity. How do I know? FINRA has said so. This, for instance, comes straight from Reg Notice 05-50: “Rule 3030 does not require that the firm supervise or even approve an outside business activity, although a firm may choose to deny or limit the ability of associated persons to engage in the activity. Rule 3030 simply requires that an associated person promptly notify the firm in writing that he is engaging in a business activity outside the scope of his relationship with the firm.”
Despite the clarity of this concept, FINRA is, nevertheless, always very interested in the OBAs of registered reps, and, perhaps more importantly, how firms deal with OBAs. This tension between, on the one hand, FINRA’s lack of jurisdiction over OBAs and, on the other, its continuing interest in OBAs is felt particularly strongly in the context of the Communications with the Public rule, NASD Rule 2210. And that’s because in the definition section of the rule, where FINRA describes the communications that the rule governs, those communications are not limited only to communications dealing with securities. Indeed, any communication – whether “correspondence” under 2210(a)(2), “retail communication” under 2210(a)(5), or “institutional communication” under 2210(a)(3) – is subject to Rule 2210 whether it relates to a security or an OBA.
Recently, the NAC issued a decision in which it reversed a hearing panel’s determination that a BD was responsible for ads that were run by a few of its registered reps for non-securities products being sold as an OBA. The NAC’s analysis highlights the important, and often ignored, fact that FINRA’s jurisdiction does, in fact, have finite limits.
In short, the registered reps disclosed to their BD – KCD Financial, Inc. – that they were operating a “CD locator service,” where they would help customers find CDs that paid the highest rates. In addition, the registered reps would sometimes kick in some of their own money towards the CD purchase so the customers would realize a higher effective rate of return than the CD itself was actually paying. They did this with the hope that the CD buyers would be pleased, and might, therefore, also be interested in buying a few securities, thus generating commissions. KCD approved the OBA.
The reps then ran ads touting the CD locator service. Because this was an OBA, KCD neither reviewed nor approved those ads.
Later, FINRA came in and concluded that the ads for the CD locator service violated Rule 2210(d) because they were misleading, promising higher returns than the CDs actually yielded, and KCD was responsible because it knew the reps were running the ads.
The case went to hearing, and FINRA won. The hearing panel censured and fined KCD $40,000. KCD then appealed to the NAC.
As I said earlier, the NAC reversed the hearing panel and dismissed the charges and the sanctions. There is no question that KCD was aware of the ads, or that they contained exaggerated statements. But, the NAC pointed out that “the content standards in NASD Rule 2210(d) apply to ‘member’ communications. Although NASD Rule 2210 contains several definitions, it does not define or discuss whether communications made by a member firm’s registered persons regarding outside business activities are ‘member communications.’” So, the NAC went about figuring out whether the CD locator service was truly an OBA – and thus not something KCD needed to supervise – or whether it was a firm activity.
Supporting the conclusion that it was an OBA, the NAC noted the following:
- There was no evidence that KCD directed or encouraged the reps to offer the CD locator services;
- There was no evidence that KCD was involved with providing the CD locator services;
- KCD had dozens of registered reps, but only three who provided CD locator services; and
- KCD did not oversee or supervise the CD locator services.
There were other facts, however, that suggested the CD locator services were, as the NAC put it, “within the scope of the representatives’ relationship with KCD”:
- The CD ads were clearly designed to solicit securities purchases, which the reps were effecting through KCD;
- Indeed, the reps made no money on the CD purchases, and only made money if they were able to convince the CD buyers also to invest in securities;
- There were “significant similarities” between how the reps sold the CD locator service and how they sold securities, employing the same d/b/a names, addresses and phone numbers as they used for their securities business;
- The reps discussed securities with the CD buyers who responded to the ads; and
- All securities purchased were done through KCD.
On balance, the NAC concluded that the firm was not involved in the CD locator service, so the ads for it were not the firm’s concern, using this language: “To rely heavily on the securities sales that resulted would blur the line between outside business activities and member firm activities: securities sales can often result from activities that are widely understood to constitute outside business activities.”
This is pretty remarkable stuff. As I have noted, repeatedly, in my posts, FINRA is always looking for angles to push its jurisdictional limits further and further, daring firms to complain, for instance, that 8210 is not as broad as FINRA maintains. Or bringing claims against unregistered individuals, insisting that, somehow, their conduct has rendered them to be associated persons. For the NAC to remind FINRA that it cannot require a broker-dealer to supervise ads relating to OBAs, even when the BD knows about the ads and knows that those ads are misleading, is a real slap in the face. And for it to have come from the NAC itself is even more surprising.
 NASD Rule 3030 was superceded by FINRA Rule 3270 effective as of 2010. Like the old rule, however, the new rule still does not require that an OBA be approved.
 There was a second charge leveled against KCD, but it is not pertinent here.