Supervision is a critical aspect of maintaining integrity and compliance within the securities industry. To ensure the proper oversight of broker-dealer firms and their associated persons, the Financial Industry Regulatory Authority (FINRA) has established a regulatory scheme consisting of three rules. Among these rules, FINRA Rule 3110 stands out as a key requirement for broker-dealer firms to establish and maintain an effective system of supervision. We will delve into the details of FINRA Rule 3110 and explore its purpose and the obligations that it imposes on broker-dealer firms.
Rule Overview
At its core, FINRA Rule 3110 aims to ensure that broker-dealer firms have a robust system in place to supervise the activities of their associated persons. The rule stipulates that the system of supervision should be reasonably designed to achieve compliance with applicable securities laws, regulations, and FINRA rules.
Key Elements
Written Supervisory Procedures (WSPs)
Under Rule 3110, broker-dealer firms are required to establish and maintain written supervisory procedures (WSPs). These procedures should be designed to effectively supervise the activities of associated persons and address the specific businesses in which the firm engages. The WSPs should cover various areas, including the supervision of supervisory personnel, review of investment banking and securities business, oversight of correspondence and internal communications, and handling of customer complaints.
The WSPs should outline:
- the individuals responsible for each review;
- the supervisory activities to be performed by those individuals;
- the frequency of reviews; and
- the manner in which documentation should be maintained.
Rule 3110 also requires broker-dealer firms to designate and register branch offices and Offices of Supervisory Jurisdiction (OSJs). This helps ensure that adequate supervision is extended to all locations where the firm conducts business. By designating these offices and implementing appropriate oversight measures, broker-dealer firms can maintain consistent supervision across all of the firms’ operations.
Internal Inspections & Transaction Reviews
To maintain effective supervision, broker-dealer firms are expected to conduct regular internal inspections and reviews. These inspections should cover a wide range of activities, including reviewing transactions for potential insider trading and ensuring compliance with customer confirmation requirements for specific transactions, such as fund transfers, address changes, and changes in investment objectives.
Benefits Of Compliance With Rule 3110
Complying with FINRA Rule 3110 brings several benefits to broker-dealer firms. By establishing a robust system of supervision, broker-dealer firms can:
- enhance compliance with securities laws, regulations, and FINRA rules — minimizing the risk of regulatory violations;
- mitigate potential misconduct or unethical behavior by associated persons — protecting the interests of clients and the integrity of the industry;
- identify and address operational deficiencies promptly — ensuring that the firm operates promptly and efficiently; and
- demonstrate a commitment to investor protection and regulatory compliance — fostering trust and confidence among clients and stakeholders.
FINRA’s Proposed Rule Change For Remote Inspections
The COVID-19 pandemic reshaped the way we work, and regulatory bodies like FINRA were not immune to this transformation. As broker-dealer firms across the financial industry adjusted to remote work environments, regulators faced the challenge of accommodating these changing work practices and adapting their inspection processes. Last summer, in response to calls from prominent brokerage broker-dealer firms, such as Charles Schwab and Wells Fargo, FINRA took action and filed proposed changes to Rule 3110 with the SEC.
The proposed changes would allow private residencies to be considered non-branch locations, reflecting the increasing trend of professionals splitting their time between home and office. This move acknowledges the potential for remote work to continue beyond the pandemic’s end. The pilot program, if approved, will allow member broker-dealer firms to remotely conduct inspections of branch offices and other locations, eliminating the need for onsite visits.
Proposed Rule Change Background
Last summer, FINRA introduced a proposed rule change to FINRA Rule 3110, which focuses on supervision. The purpose was to allow member broker-dealer firms to perform remote inspections of some or all branch offices and locations. The goal of this three-year pilot program is to fulfill the obligations outlined in Rule 3110(c), without the necessity of physical, onsite inspections. On December 15, 2022, FINRA filed Partial Amendment No. 1 to address specific concerns raised during the comment period and improve the proposed rule.
Proposed Rule’s Key Amendments
Risk Assessment Factors
FINRA proposes to amend Rule 3110.18(b) by introducing a new subpart. This addition, paragraph (b)(2), outlines the factors that broker-dealer firms must consider and document when conducting risk assessments. By incorporating these factors into their risk assessment process, broker-dealer firms are expected to identify high-risk locations or sites with “red flags.” To ensure compliance, FINRA anticipates that broker-dealer firms will establish or modify relevant compliance and supervisory policies and procedures accordingly.
Certain Member Firm Exclusions
Subparts (1)(A)(iii)-(vi) have been added to Rule 3110.18(c), proposing the exclusion of specific member broker-dealer firms and their offices or locations from the pilot program. These exclusions are based on events or activities that raise investor protection concerns. Decisions regarding exclusions will be made by FINRA, taking into account criteria, such as notices received from FINRA, membership status, and violations of Rule 3110(c).
Remote Inspection Baseline Requirements
To ensure the effectiveness of remote inspections, subpart (1)(B) introduces new controls for books and records, surveillance, and technology tools. Member broker-dealer firms participating in the pilot program must meet certain conditions, including maintaining a recordkeeping system capable of preserving required records, providing prompt access to records, and implementing appropriate surveillance and technology tools for risk supervision.
Ineligibility For Remote Inspections
Subparts (2)(A)(v)-(vii) expand the list of conditions that render member broker-dealer firms ineligible for remote inspections. These conditions include being subject to a mandatory heightened supervisory plan, being statutorily disqualified, or handling customer funds or securities. These amendments aim to strengthen the pilot program by ensuring that participating broker-dealer firms meet certain eligibility criteria.
Pilot Period Eligibility Conditions
Subparts (2)(B)(i)-(iii) introduce additional eligibility conditions for remote inspections during the pilot period. These conditions include the use of the member’s electronic system for electronic communications, supervision of correspondence and communications with the public, and the absence of physically or electronically maintained member books or records at the office or location.
Compliance Enforcement
FINRA proposes to add subpart (k) to Rule 3110.18, empowering FINRA to determine a member’s ineligibility for the pilot program when the member fails to comply with the requirements outlined in Rule 3110.18. In such cases, FINRA will issue a written notice to the member, prompting them to resume onsite inspections.
FINRA’s Re-Proposed Amendments for Residential Supervisory Locations
In March 2023, FINRA re-proposed amendments to its supervision rule, after concerns expressed by the industry in response to the initial attempt, which was withdrawn in 2022. In response to feedback, the amendments make several adjustments, including:
Residential Supervisory Locations (RSL)
Under the proposed amendments, FINRA introduces the concept of Residential Supervisory Locations or RSLs. These locations would allow broker-dealer firms to conduct specified supervisory activities at private residences, while considering them to be non-branch offices, deviating from the current classification as Offices of Supervisory Jurisdiction (OSJs) under FINRA Rule 3110(f). This move by FINRA aims to align its supervisory rules with the prevalent work-from-home practices in the industry.
Guardrails & Restrictions
The proposed amendments outline certain guardrails and restrictions for RSL activity, in order to ensure compliance with existing regulations. For instance, handling customer funds or securities at the RSL would be strictly prohibited. Moreover, customer meetings and sales activities cannot take place at the location. Periodic inspections of RSLs would also be required, with the presumption that they take place at a frequency of at least every three years, in contrast to the annual inspection requirement for OSJs and other supervisory branch offices.
Addressing Industry Concerns
In response to feedback, the amendments make several adjustments, including:
- prohibiting physical or electronic maintenance and preservation of records at the RSL;
- expanding the criteria for ineligibility, encompassing suspended broker-dealer firms, broker-dealer firms with less than 12 months of FINRA membership, and residences of associated persons subject to investigations or actions related to supervision failures; and
- requiring broker-dealer firms to provide quarterly lists of designated RSLs to FINRA.
How FINRA Rule 3110 Affects Individual Advisors
While Rule 3110 primarily impacts the obligations of member firms, it indirectly affects individual financial advisors who work under the supervision of these firms, especially those who work from home or have a remote setup. Here’s how Rule 3110 can impact individual financial advisors:
Enhanced Supervision: Rule 3110 imposes stricter supervision requirements on member firms, including the establishment of a supervisory system and the designation of a principal who oversees and reviews the activities of associated persons. As an individual financial advisor, you may experience increased supervision and monitoring by your firm to ensure compliance with regulatory obligations. This can involve the use of technology to monitor communications, track activities, and ensure adherence to compliance policies. The constant surveillance may create a feeling of being micromanaged or hinder the sense of autonomy that advisors might have enjoyed in a traditional office setting.
- Compliance With Policies & Procedures: Member firms are required to establish and maintain written supervisory procedures (WSPs) to govern the activities of their associated persons. Individual financial advisors must adhere to these WSPs and comply with the policies and procedures outlined by their firm. This includes conducting proper due diligence, maintaining accurate records, and following the firm’s guidelines for client interactions, suitability assessments, and disclosure requirements. Remote work setups may present challenges, in terms of communication and collaboration with colleagues and supervisors. Advisors may face difficulties in obtaining timely guidance or clarification on compliance-related matters, which can impact their ability to serve clients effectively. It is crucial for firms to establish efficient communication channels and provide the necessary support to remote advisors to mitigate such challenges.
- Continuing Education & Training: Rule 3110 emphasizes the importance of ongoing education and training to ensure that associated persons, including individual financial advisors, have the necessary knowledge and skills to fulfill their duties. As an individual financial advisor, you may be required to participate in regular training programs, stay updated on regulatory changes, and enhance your professional knowledge to meet the firm’s compliance standards.
- Recordkeeping & Reporting: Rule 3110 places significant importance on accurate recordkeeping and reporting by member firms. As an individual financial advisor, you are responsible for maintaining and documenting your activities in accordance with your firm’s recordkeeping policies. This includes documenting client interactions, investment recommendations, and any other information required by regulatory authorities. Advisors working from home need to ensure that they have adequate systems in place to maintain accurate records and documentation. Meet regulatory requirements when managing compliance obligations remotely may require additional effort and attention to detail.
- Potential Security & Privacy Risks: Working remotely introduces potential security and privacy risks, particularly when it comes to handling sensitive client information and maintaining data confidentiality. Advisors must ensure they have robust cybersecurity measures in place to protect client data, maintain secure communication channels, and comply with privacy regulations. Firms need to provide clear guidelines and resources to address these risks effectively.
- Compliance With Ethical Standards: Rule 3110 reinforces the need for individual financial advisors to uphold high ethical standards and act in the best interests of their clients. It requires firms to establish and enforce a code of ethics that addresses potential conflicts of interest, insider trading, and other prohibited activities. As an individual financial advisor, you must adhere to these ethical standards and disclose any conflicts of interest to your clients, as required by regulatory guidelines.
It’s important for individual financial advisors to familiarize themselves with their firm’s policies and procedures related to Rule 3110 and ensure compliance with the supervision requirements outlined by FINRA. By doing so, financial advisors can contribute to the maintenance of a robust regulatory framework and foster trust and confidence in the industry.
Industry Feedback & Perspectives
Notably, industry groups, such as the North American Securities Administrators Association (NASAA) and the Public Investors Advocate Bar Association (PIABA), opposed the initial proposal, asserting that remote supervision could undermine investor protection and that it “leaves considerable opportunity for advisors working from home to skirt the rules.” These groups are expected to provide additional comments on the re-proposal. NASAA, for instance, has previously urged the SEC to require a comprehensive examination sweep supervised by the SEC, a public report on the findings, and a multi-step notice and comment process before FINRA’s RSL rules are finalized. While FINRA did not engage in that specific process, it did address other concerns raised by NASAA and other commenters.
Industry Reactions
Amid the ongoing challenges faced by broker-dealers in bringing their personnel back to the office, many are expected to support the proposed amendments. While some industry groups have voiced opposition, the silence of other broker-dealers may indicate tacit support for the proposal and recognition of the practical difficulties associated with returning to traditional office settings.
Next Year’s Likely Changes To FINRA Rule 3110
The SEC had a deadline to respond to FINRA’s Remote Inspection rule proposal by mid-April, while FINRA’s most recent filing extends remote inspections through the end of 2023.
Supervision is a vital aspect of maintaining a well-regulated securities industry. FINRA Rule 3110 plays a central role in ensuring that broker-dealer firms have an effective system of supervision in place.
As the financial industry continues to embrace remote working, supervision practices must adapt. FINRA’s re-proposed amendments for Residential Supervisory Locations reflect a proactive response to these evolving work arrangements.
If approved, these amendments will offer broker-dealers the flexibility to conduct certain supervisory activities at private residences, while upholding regulatory standards. As the SEC evaluates the re-proposal, and industry groups provide feedback, the final outcome will shape the future of supervision and work arrangements in the securities industry. By striking the right balance, the industry can maintain effective oversight, while embracing the benefits of remote working.
To mitigate the negative consequences of Rule 3110 for advisors working from home, member firms should develop comprehensive policies and procedures that address the unique challenges of remote work. This may include providing adequate training and support, leveraging technology for efficient communication and supervision, and establishing clear guidelines for compliance obligations and recordkeeping in remote settings. By proactively addressing these issues, firms can help advisors navigate regulatory requirements while maintaining their productivity, job satisfaction, and overall well-being.