In the past, if the Financial Industry Regulatory Authority Inc. requested documents or information unrelated to the securities business, broker-dealers or registered representatives often didn't comply, responding in a way reminiscent of the soup stand owner on “Seinfeld” by stating (or thinking): “No documents for you!”
Finra is out to change that, and broker-dealers and reps need to understand the implications of the regulator's changes.
Due to recent changes to Rule 8210, Finra may now think that it has virtually unlimited authority to request documents and information (including third-party documents), with no provisions for firms or individuals to object formally to the requests. Unlike in court, where a party can “take it to the judge” if a subpoena is overbroad or unwarranted, in Finra-land, the only option is to refuse to produce, be sanctioned for violating Rule 8210 and then appeal to the Securities and Exchange Commission.
The changes to Rule 8210 came about following the 2006 landmark enforcement case against Jay Alan Ochanpaugh, in which Finra's predecessor, NASD, barred a rep for violating the rule because he failed to produce checks written by a church that he founded. NASD argued that he had “possession and control” of the checks because he was the church's president and a signatory of the church's bank account.
NASD then argued that the checks were his “book, records and accounts,” subject to its Rule 8210.
Mr. Ochanpaugh said he wasn't required to produce the checks, because they belonged to a third party — the church — which wasn't a broker-dealer.
The SEC overturned the bar, finding that Rule 8210 had limits. For example, the rule might not apply to third-party documents or documents containing confidential third-party information unrelated to securities transactions, even if the documents were in the possession or control of a broker-dealer or rep.
The SEC saw the Ochanpaugh case as an opportunity to order NASD to make a “fuller exploration of the appropriate scope of Rule 8210.”
This led NASD, now Finra, to issue several amendments that went into effect Feb. 25.
Finra now can demand documents in the “possession, custody or control” of a firm or a rep, including documents owned by third parties.
Because the industry was confused and concerned about this authority, Finra published a set of FAQs in May to provide some guidance.
That guidance, unfortunately, didn't alleviate the industry's concerns. For example, it made the unhelpful comment that whether a firm or a person had “control” over a specific document was a “facts and circumstances” determination.
The FAQs did include examples of hypothetical Finra requests. Some were obvious and would have surprised no one under the prior version of the rule. In one hypothetical example, Finra requested books and records from an associated person concerning his insurance business for an investigation of potential undisclosed outside business activities. Finra said that this request was proper because the documents were in the associated person's “possession, custody or control” and were relevant to the inquiry.
What is improper?
Unfortunately, all the hypothetical requests in the FAQs were “proper,” leaving unclear what Finra considers to be an improper request under amended Rule 8210. It would have been extremely helpful to broker-dealers, reps and, presumably, to Finra staff members, if the FAQs had identified requests that were beyond the scope of the amended Rule 8210, highlighting to the industry — and to Finra's staff members — some boundaries with respect to document requests.
The FAQs also ignored basic issues, such as:
• How will Finra handle investigations that get sidetracked because there is a dispute over whether a firm or a rep has possession, custody or control over a document?
• Will Finra bring charges if there is a delay in production because the parties were trying to sort out the “possession” issue?
• Will Finra broaden its reviews of outside business activities beyond disclosure and vetting of proposed activities?
• Will Finra expect broker-dealers to be aware of all documents in a rep's possession, custody and control, and to review them for potential red flags?
Certain issues have been considered beyond Finra's authority, such as conduct traditionally regulated by others, including investment adviser activities, commodities trading and traditional insurance activities. Will we see jurisdictional creep, whereby Finra asserts violations of its rules if it doesn't like an SEC investment adviser's fee practice, a certified public accountant's tax advice or a soup stand owner's “No soup for you!” policy?
Because Finra's guidance was lacking, we don't know exactly how the regulator will use those documents. However, we do know that part of amended Rule 8210 expressly authorizes Finra to obtain books, records and accounts relating to three topics: outside business activities, private securities transactions and possible violations of so-called just and equitable principles of trade.
Lines of defense
Firms, therefore, may want to:
• Learn more about outside business activities during their review process, routine audits and annual compliance certifications, and then impose greater limits on them.
• Compile a list of books, records and accounts potentially discoverable under amended Rule 8210, and consider reviewing those books, records and accounts for red flags.
• Question certain higher-risk reps about documents in their possession, custody or control related to outside business activities.
• Communicate with associated persons and train them about the possible implications of the new rule on their non-firm-related activities.
Although the scope of the rule is daunting, firms that prepare now may be able to put themselves in a better position when they face a broad request from Finra. If firms and individuals don't focus on these issues, they may find themselves in the unenviable position of having to produce documents to Finra that they haven't seen before, or that raise red flags about their conduct or their rep's behavior.
Ultimately, responses to Rule 8210 requests may change from “No documents for you!” to situations where firms and reps may need to “do the opposite,” as George Costanza might say, and produce all third-party documents or risk being sanctioned by Finra.
Eric A. Arnold and Brian L. Rubin are partners at Sutherland Asbill & Brennan LLP.