Steve Semerdjian, Partner, Loeb & Loeb LLP
Stephen Cohen, Partner, Loeb & Loeb LLP
On March 29, 2011, the Financial Industry Regulatory Authority (FINRA) published for industry comment Proposed Rule 31901, which clarifies the scope of its members’ obligations and supervisory responsibilities for functions which they outsource to a third-party service provider. This proposed Rule memorializes, for the first time, the guidance in NTM 05-482 in the form of an affirmative set of supervisory obligations for which a broker-dealer and its personnel will be held accountable. As a result, failure to comply with the proposed rule would enable FINRA to more readily cite deficiencies on FINRA exams, which could lead to an increase in disciplinary events and fines for member firms.
Changes Impacting All Member Firms Utilizing Outsourcing Services
The proposed Rule provides that when a member firm outsources a function related to its business as a broker-dealer to a third-party service provider, the member firm:
is not relieved of its obligation to comply with applicable securities laws and regulations, and FINRA and Municipal Securities Rulemaking Board (MSRB) rules; and
cannot delegate its responsibilities for, or control over, any outsourced functions performed by such third party.
In addition, any such member firm must have supervisory procedures in place to ensure that its outsourcing arrangements are reasonably designed to comply with securities laws and regulations, and FINRA and MSRB rules. Such procedures must include ongoing due diligence of both current and prospective third-party service providers to which they outsource broker-dealer functions.
As drafted, the proposed Rule applied not just to third-party service providers (which includes any affiliate of a member firm to which such services are outsourced), but also to any sub-vendors (i.e., subcontractors) they used to provide the outsourced services. However, in a recent conversation with Loeb & Loeb, Grace Vogel, FINRA Executive Vice President, explained that as a result of FINRA’s review of the comments received on the proposed Rule3, FINRA is strongly considering eliminating the requirements around sub-vendors. The revised Rule will likely recommend as a good business practice, but not require, that member firms should require their third-party service providers to notify them of sub-vendor relationships.
Changes Impacting Clearing or Carrying Firms Utilizing Outsourcing Services
In addition to the foregoing overall requirements, the proposed Rule also imposes additional restrictions and obligations that apply solely to a clearing or carrying member firm and its third-party outsourcing arrangements.
Restrictions Applicable to Certain Clearing or Carrying Member Firms’ Activities
Under the proposed Rule, clearing or carrying firms outsourcing the following activities must have these activities performed by persons or entities that are “Associated Persons” (as defined in Article 1(gg) of FINRA’s By Laws) of the clearing or carrying firm (and “Registered Persons” (as contemplated under FINRA Rule 1031) where the activity requires licensing and registration) subject to the direct control and supervision of the member firm:
the movement of customer or proprietary cash or securities;
the preparation of the net capital and customer protection computations; and
the implementation and maintenance of compliance and risk management systems.
As it relates to the movement of cash or securities, FINRA proposed an alternative approach to the foregoing requirement in its supplementary materials to the proposed Rule. Under this approach, third-party service providers may post entries to the clearing or carrying member firms’ ledgers if the firms review each posting prior to the close of business on the day following the posting. FINRA goes on to clarify that a clearing or carrying member firm may comply with the supervisory review requirement by substantiation of financial balances and spot-check reviews of individual entries.
As it relates to the preparation of net capital and customer protection computations, FINRA also has proposed that the performance of underlying calculations in aid of the preparation of the net capital and customer protection computations would be ministerial functions (which are excluded from the proposed Rule) that could be performed by a third-party service provider if the member firm’s Associated Person reviews and understands net capital and customer protection computations and has the ability to explain the rationale behind the such service provider’s calculations to FINRA.
Similarly, as it relates to the implementation and maintenance of compliance and risk management systems, the proposed rule would allow third-party service providers to perform basic calculating, logging and maintaining of lists that are preparatory to creating related books and records, as well as review output from compliance and risk management systems. However, analysis and/or conclusions based upon the data from compliance and risk management systems would have to be performed by an Associated Person of the member firm.
Oversight of Third-Party Service Providers by Clearing or Carrying Member Firms
The proposed Rule requires that for a clearing or carrying member firm, the supervisory procedures noted above must include procedures that: (i) enable the member firm to take prompt corrective action where necessary to achieve compliance with applicable securities laws; and (ii) require the member firm to approve transfers of duties by a third-party service provider to its sub-vendors.
Notification Prior to Entering into an Outsourcing Arrangement by Clearing or Carrying Member Firms
The proposed Rule requires a clearing or carrying member firm that enters into an outsourcing arrangement for the performance of activities related to such member’s business as a regulated broker-dealer to provide FINRA with notification of such within 30 calendar days of its execution. In addition, the proposed Rule requires that within three months of the Rule’s effective date, a clearing or carrying member firm must notify FINRA of all of its outsourcing arrangements in effect as of such effective date. Such notifications must specify:
the functions being outsourced;
the identity and location of the third-party service provider and any sub-vendors;
the identity of the third-party service provider’s regulator (if any); and
a description of any affiliation between the member firm and the third-party service provider.
FINRA suggests that although the proposed Rule does not itself require a clearing or carrying member firm to submit prospective outsourcing arrangements to FINRA for review, they might wish to do so on their own accord.
Steve Semerdjian is a Partner in the Advanced Media & Technology Department at Loeb & Loeb LLP in New York, and a member of Loeb’s Outsourcing & Technology Group. Steve can be reached at (212) 407-4218 or email@example.com.
Stephen Cohen is a Partner in the Corporate Department at Loeb & Loeb LLP in New York, and a member of Loeb’s Financial Reform Task Group. Stephen can be reached at (212) 407-4279 or firstname.lastname@example.org.