Let’s talk about commissions today. Or, as they are sometimes referred to, transaction based compensation. Specifically, who can receive commissions. Actually, that’s not phrased correctly. The correct phrasing of this issue, courtesy of FINRA Rule 2040, would be: to whom a broker-dealer may legally pay commissions? According to that rule, BDs can only pay commissions to a registered BD or to registered persons. Seems straightforward enough, but, in reality, it causes all kinds of problems. Indeed, in any given week, you are bound to see some action taken by FINRA, or the SEC, that centers on the improper payment of commissions to someone.
Let’s start with a common scenario that still manages to cause problems: there is a registered person (typically a principal, but not necessarily) who owns and runs his own branch office, where a bunch of other people work, some registered, like the RRs, and some unregistered, like, say, the receptionist. He operates the branch through some legal entity that he’s created, like an LLC. The LLC pays everyone at the end of the month. The sole source of the money that the LLC uses to pay everyone comes is a check from the BD for all the commissions earned at the branch that month. The LLC then cuts checks to everyone for their share of the commissions (in the case of the RRs), or for their monthly salary (in the case of the receptionist).
Here’s the deal: the BD cannot pay the commissions directly to the LLC. Why? Because the LLC is not registered. Accordingly, the BD has to pay the commissions to the registered person who owns the LLC. If it doesn’t, then it will find itself named as a respondent in a disciplinary action, such as this AWC from a few years ago. I think most everyone understands this, and abides by this general principle.
The problem with this scenario is that it suggests that as long as a broker-dealer makes the initial commission payment to a registered person, it doesn’t matter to the broker-dealer what that person then does with the money. Take the above example, where the BD properly pays commissions to the registered owner of the branch, who then uses that money to pay all the expenses of his branch office. Including salaries to the unregistered receptionist. Assuming that the commission payment represents the sole source of revenue for that branch, it is rather clear that the unregistered receptionist – not to mention the landlord, the utility company, the delivery guy who brings in the pizza for the monthly meeting – is, in fact, being paid money that came from commissions. But, it seems that no one has any problem with this, given how common this arrangement is, and that’s fair.
But it’s not that easy, however. The fact is, there is a lot of guidance from the SEC that makes it clear that what happens after the initial payment of commissions to a registered person does, in fact, matter. Like this 20-year old no-action letter (or, more accurately, denial of a no-action request). In that case, the SEC declined to provide no-action relief to a BD that made this proposal:
- The BD would pay commissions directly to nine RRs (all owners of an entity they created for administrative reasons);
- The nine RRs would then deposit their commission checks into their respective personal accounts;
- The nine RRs would then write their own checks to their co-owned entity;
- The entity would deduct things like overhead, payroll taxes, etc., for of the nine RRs; and, finally,
- The entity would cut the checks, sans the deductions back to the nine RRs.
What do you mean the SEC rejected this proposal? After all, the BD paid the commissions directly to the RRs, not their unregistered entity. Isn’t that exactly what 2420 requires? I concede that there was more to the SEC’s analysis than this. I also concede that the SEC has granted no-action relief in “employee leasing” situations. The point, however, is this, and it’s simple: if you are a BD, you cannot blithely ignore what your RRs do with their commission payments, simply because you were clever enough to have been aware of Rule 2420 and ensured that all commission payments were made directly to registered persons.
I’ll give you one more scenario to think about, something even more baffling. Let’s take the same owner of the branch I talked about earlier, same branch, same facts, but with one big difference: let’s presume that this guy is not the sole owner of the LLC under which he runs his branch. Instead, let’s presume that the he is only a co-owner, and the other co-owner is not registered. Let’s also presume that the unregistered co-owner has ZERO role in the operation of the branch; his sole function is to cash the check that he receives each month representing his share of the profits earned at the branch. Is this ok under 2420?
Before I answer, consider this: at the firm level, it is perfectly fine for an unregistered person to serve as a “passive” owner. As long as you are not involved in the day-to-day management of the BD, you can own some or all of the BD – and be entitled to its profits – without having to register in any capacity. (Granted, FINRA will push back hard to confirm that the ownership is truly “passive,” but it’s hardly impossible to make this showing.)
Given this, it would certainly seem that the answer to the question I posed two paragraphs ago must be “yes,” right? I mean, if passive ownership is ok at the firm level, then it must also be ok at the branch level. That’s just simple logic.
Well, shame on you for thinking logic applies when it comes to FINRA. The fact is, I have had a FINRA examiner tell me, in this exact circumstance, that it was a 2040 violation for the registered co-owner of the branch to share profits with the unregistered, passive co-owner of the branch. I pushed back – hard – and enough time has transpired since then with no follow-up that I can only presume that the issue has died on the vine (or the examiner quit FINRA and the exam got forgotten – not an unheard of story).
But, it goes to show you, again, the lesson of today’s post: as a BD, your job doesn’t end when you have ensured that commissions are paid directly to registered people. No, you have to go further, you need to ask enough questions so you understand what those people are doing with that money. If they simply deposit it into their personal checking account, and use it to pay their household expenses, no one is going to claim you’ve violated 2040 because the rep’s spouse wrote a check off of that account to pay the mortgage. But…if the rep gives his commission check to an entity he created to run the operations of his branch office, you had better, at a minimum, be aware of that, and, even better, have a memo in your file reflecting your reasoned conclusion why this did not implicate Rule 2420.
 FINRA, of course, only has jurisdiction over BDs and individuals associated with a BD. If someone is paid commissions but is not properly registered, while FINRA may properly take issue with the BD payor, FINRA has no standing to do anything to the unregistered recipient because it does not have jurisdiction over that person/entity. But, because the receipt of transaction based compensation is deemed to be a hallmark of acting as a broker-dealer (not necessarily a dispositive fact, but pretty damn telling), this means that the unregistered recipient may find him/herself in hot water with the SEC, for acting as an unregistered BD.
 Again, the reason this guidance comes from the SEC, not FINRA, is that it is the SEC that dictates the circumstances under which an entity needs to be registered as a BD.