Outside business activities: Getting assessments and monitoring right

June 7, 2016

By Julie DiMauro, Regulatory Intelligence

(Thomson Reuters Regulatory Intelligence) – Broker-dealers and investment advisers must appreciate their obligations to report on their employees’ outside business activities and implement effective practices related to monitoring and supervising them.

Doing so entails identifying the red flags and potential problems by reviewing regulatory examinations related to outside business activities, or OBAs, and studying how firms are addressing them.

To ensure that outside activities are promptly reviewed and possible conflicts of interests are mitigated, compliance must drive the process of obtaining outside activity declarations and impressing upon the business the importance of doing so promptly and fully. The compliance team must design and pattern its outside activity-declaration forms to ensure employees disclose all relevant aspects.

The regulatory requirements

The Financial Industry Regulatory Authority regularly makes broker-dealer supervision of OBAs a top exam priority, and it made the rule covering such disclosures, FINRA Rule 3270, more specific and strict six years ago.

There were a couple of significant changes that tightened notification terms for outside activities.

The former rule required a registered person to provide prompt written notice whenever the person was employed by or accepted any compensation as a result of an outside business activity, other than passive investment.

New Rule 3270 requires prior written notice, as opposed to notice after the fact, whenever any registered or otherwise supervised person receives compensation, or expects to receive compensation, as a result of any outside business activity.

These changes were designed to help firms determine sooner the nature of an activity in question and impose the proper level of supervision.

Member firms are required to review the activity and determine if it is allowed or prohibited in accordance with the rule, although the firm may also set its own, stricter limits and restrictions related to the activity.

The review and decision process must be documented and filed. To ensure compliance, firms must identify technology and processes for managing the OBA request submission, as well as processes for the supervisory review, approval and response, status tracking, registered representative attestation, documentation and reporting.

Although not mentioned in the rule, an actual or potential conflict of interest could arise where the activities of the employee’s immediate relations or other close personal relationships could otherwise affect his or her employment obligations. Such OBAs that could pose such a conflict of interest are equally imperative for employees to disclose to the compliance department.

Regulatory actions

On March 26, 2015, FINRA fined Oppenheimer & Co. Inc. $2.5 million and ordered it to pay restitution of $1.25 million for failing to supervise a former registered representative, who stole money from his customers by persuading them to wire funds to entities that he owned or controlled, and for failing to prevent excessive trading in their accounts.

FINRA said the firm, among other failings: (1) failed to adequately investigate the broker prior to hiring him even though he was subject to 12 reportable events, including criminal charges and seven customer complaints; (2) failed to place him under heightened supervision even after learning that his business partners had sued him for defrauding them out of several million dollars; and (3) took insufficient steps after it became aware that the registered representative engaged in several outside business activities that he had not previously disclosed to the firm.

In addition to the fine and restitution, FINRA required the firm to retain an independent consultant to conduct a comprehensive review of the adequacy of the firm’s supervisory systems and procedures and training relating to its violations.

In a Securities and Exchange Commission settlement against an investment adviser last year in April, Blackrock Advisors, LLC, agreed to pay a $12 million penalty and engage an independent compliance consultant related to its failure to disclose a conflict of interest involving a portfolio manager’s outside business activity.

In the case, Blackrock’s chief compliance officer was singled out for his failure to report a “material compliance matter” to the board of directors. The firm was also cited for its failure to adopt and implement policies and procedures for the outside activities of employees and said the compliance officer caused the failure.

The “conflict” or outside business activity involved a portfolio manager’s personal investment in a family-owned and operated energy company. The portfolio manager was also the general partner of the private company and personally invested approximately $50 million. The private company formed a joint venture with a publicly-traded company that eventually became the largest portfolio holding in Blackrock Energy & Resources Portfolio, which was managed by the portfolio manager.

The SEC found that Blackrock and the CCO knew and approved of the portfolio manager’s investment but failed to disclose the conflict to either the boards of directors or clients.

The action by the SEC was a first to hold a CCO personally liable under Rule 38a-1 for failing to report a material compliance matter — such as violations of the adviser’s policies and procedures — to a fund board.

Private securities transactions

Any analysis of OBAs could bring to light activities subject to the requirements of FINRA Rule 3280, which govern the private securities transactions of associated persons of members. FINRA defines a private securities transaction as “any securities transaction outside the regular course or scope of an associated person’s employment with a member.”

FINRA Rule 3280 applies to associated persons of a member, and according to the FINRA by-laws, associated persons include both registered and non-registered persons. This means all employees of a broker-dealer should report outside business activities, regardless of the employee’s activities with the member.

If the firm fails to conduct a thorough analysis, the oversight could put the member firm at risk of violating the rule.

The compliance department should identify whether or not an employee’s activity would constitute a private securities transaction by asking questions such as:

  • Do you find investors for any type of offering as part of your outside activity?
  • Will you be involved in buying or selling interests in any offering as part of your outside activity?
  • Do you receive direct or indirect compensation for involvement in any of the above activities?

A “yes” answer to any of the above questions could indicate the employee’s involvement in private securities transactions. FINRA Rule 3280(b) requires that the employee provide written notice to the member prior to any participation in a private securities transaction for another entity.

After verifying that an outside business activity constitutes involvement in private securities transactions, the designated principal should request that the employee complete the notice required by FINRA Rule 3280(b). The notice should include details of the proposed role of the employee and whether the employee has received or may receive compensation in connection with the transaction.

Firms frequently overlook Rule 3280(c)(2), which requires firms to record each private securities transaction on the books and records of the member and actually supervise the transaction as if it were executed on behalf of the broker-dealer.

Transactions not involving compensation would not require the firm to abide by this part of the rule, but FINRA defines “indirect” compensation broadly and may include salary and management fees.

Best practice pointers

When an employee requests approval to engage in an outside business activity, a FINRA-regulated firm should consider the following steps:

  • Attestations to comply should be obtained early. Firms should require all employees to disclose to the CCO any outside business activities in which the employee would like to continue upon hiring and obtain annual attestations from employees that they are not engaging in any other outside business activities beyond those that have been disclosed and approved.Most firms also have a policy, and receive attestations, that employees will obtain the CCO’s prior approval before engaging in any future outside business activities. To the extent an employee is engaging in approved outside business activities, firms should require the employee to inform the CCO of any changes in, or new conflicts of interest relating to, the approved outside business activities of which the employee later becomes aware.
  • Analyze and resolve conflicts of interest. First, each outside business activity must be analyzed to determine whether it would create any actual or potential material conflicts of interest with the fund sponsor’s clients. Each conflict of interest should be analyzed to determine whether it can be appropriately mitigated through the adoption of certain policies and procedures and by disclosure to investors. Even if a conflict of interest can be mitigated through controls, such as specifically crafted policies, disclosure is likely warranted.
  • Document decision-making. The analyses and the manner in which conflicts of interest relating to outside business activities are resolved should be particularly documented.
  • Monitor approved outside business activities. Although the compliance team should draft policies relating to employees engaging in permitted outside business activities — which require employees to inform the CCO of any changes in such activities — CCOs should take some steps to stay informed.CCOs should consider periodically obtaining a certification from the employee that relates to the specific circumstances of the outside business activities, interviewing the employee about them, and performing additional diligence related to such outside business activities.Even if there was no change in the outside business activities to raise a conflict of interest, there could have been a change to the firm itself and its business that present new conflicts.
  • Resolve violations, use as a training tool. If a fund sponsor becomes aware that an employee is engaging in outside business activities without prior approval, it should require the employee to cease the outside business activities until further review is conducted and consider sanctioning the employee.The employee may have also violated the firm’s Code of Ethics, and both violations offer the compliance team an opportunity to train employees about the rule and ethics violations underpinning the non-reporting of such actions.Training on the reporting of outside business activities — no matter how unconnected to the firm’s practice — should happen during a new employee’s orientation, and periodic reminders should be supplied to remind employees of the obligation and how to supply the requisite attestations.

(This article was produced by Thomson Reuters Regulatory Intelligence and initially posted on June 1. Regulatory Intelligence provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 400 regulators and exchanges. Follow Regulatory Intelligence compliance news on Twitter: @thomsonreuters)

(Julie DiMauro is a regulatory intelligence and e-learning expert in the GRC division of Thomson Reuters Regulatory Intelligence. Follow Julie on Twitter @Julie_DiMauro. Email Julie at julie.dimauro@thomsonreuters.com)

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