Back in December 2014, the Securities and Exchange Commission (“SEC”) approved a Financial Industry Regulatory Authority (“FINRA”) rule governing transaction-based payments to unregistered persons. The FINRA rule—Rule 2040—became effective on August 24, 2015. I understand that FINRA is currently considering providing members and the industry with written guidance so that their registered representatives can receive more favorable tax treatment of their earned income by either i) forming individual corporate entities to receive commissions, or ii) form selling groups with other registered representatives from the same broker-dealer so that they can engage in succession planning. At least I hope that is the case!
The Rule
Rule 2040(a) states, “[n]o member or associated person shall, directly or indirectly, pay any compensation, fees, concessions, discounts, commissions or other allowances to: (1) any person that is not registered as a broker-dealer under Section 15(a) of the Exchange Act but, by reason of receipt of any such payments and the activities related thereto, is required to be so registered under applicable federal securities laws and SEA rules and regulations; or (2) any appropriately registered associated person unless such payment complies with all applicable federal securities laws, FINRA rules and SEA rules and regulations.” In short, this paragraph states that broker-dealers cannot i) pay unregistered persons or entities, unless the payment would otherwise be legal, and ii) pay registered representatives unless the payment is legal.
What Does it Mean for Payers and Payees of Transaction-Based Compensation?
This particular method of drafting begs the question of what is legal in terms of paying or assigning transaction-based compensation to unregistered persons or entities. However, this was not a matter of poor drafting. It was a deliberate decision, because FINRA has long deferred to the SEC to determine whether or not a person or entity should be registered as a broker-dealer.[i]
There currently exist ways for broker-dealers and registered representatives to prove to FINRA that they are in compliance with Section 15(a) of the Exchange Act. A supplement to Rule 2040 gives members additional guidance. This paragraph states:
FINRA expects members to determine that their proposed activities would not require the recipient of the payments to register as a broker-dealer and to reasonably support such determination (emphasis added). Members that are uncertain as to whether an unregistered person may be required to be registered under Section 15(a) of the Exchange Act by reason of receiving payments from the member can derive support for their determination by, among other things, (1) reasonably relying on previously published releases, no-action letters or interpretations from the Commission or Commission staff that apply to their facts and circumstances; (2) seeking a no-action letter from the Commission staff; or (3) obtaining a legal opinion from independent, reputable U.S. licensed counsel knowledgeable in the area. The member’s determination must be reasonable under the circumstances and should be reviewed periodically if payments to the unregistered person are ongoing in nature. In addition, a member must maintain books and records that reflect the member’s determination.
This guidance is not particularly helpful for a registered representative hoping to establish a selling group operate a corporate entity for expense paying and marketing purposes.[ii] In a line of SEC Interpretive No-Action Letters, the SEC has suggested that it would reserve the right to bring enforcement proceedings against entities that receive securities-based compensation from registered representatives by assignment or otherwise.[iii]
However, No-Action Letters are not binding legal authority. These letters merely serve as the opinions of the Commission on arguable questions of the law. I have long believed that these No-Action Letters reach the wrong legal conclusion, and I have counseled numerous clients on how to establish selling groups in a way to reduce their overall risk.
I would be doing everyone a disservice if I did not mention the recent case of Carey v. Bumstead in Washington . There, a state appellate court unanimously placed great weight on the SEC No-Action Letters in deciding a dispute among two registered representatives. Interestingly, the court acknowledged that it wasn’t bound by SEC No-Action Letters. [iv]
While I appreciate the SEC’s, FINRA’s and Washington State’s intent of preventing fraud and questionable payment arrangements, they have gone too far interpreting the law. That is why I believe (i) the pending guidance should be released expeditiously, and (ii) in the interim, the SEC and FINRA should cease issuing deficiencies from these alleged commission sharing arrangements.
[i]See NASD Interpretive Letter to Ted. A. Troutman, Esquire, Muir & Troutman (Feb. 4, 2002).
[ii] See Herbruck, Alder & Co. (May 3, 2002)(Firm denied no-action relief where all nine owners were registered representatives of a broker-dealer who would receive commission checks directly from broker-dealer, deposit them in their own personal accounts, and then write a check to the firm. The purpose of combining the revenues was that the firm could deduct “overhead, payroll taxes, and fringe benefit costs” and remit the balance to the employee(s).); Wolff Juall Investments, LLC (May 17, 2005)(No relief granted where registered representatives proposed to deposit their commissions with a limited liability corporation not registered as a broker-dealer to cover expenses with the non-registered entity to distribute the remainder to the registered representatives.); Birchtree Financial Services, Inc. (Sept. 22, 1998)(No Action Relief denied where Birchtree Financial Services requested the payment of commissions to an entity owned and operated solely by two registered representatives. Relief also denied for the assignment of commissions by the two registered representatives to an entity. The entity was created to pay operating expenses and health care benefits for employees.); Century Investment Group Incorporated (Jan. 29, 1996)(SEC Division of Market Regulation would not offer relief where certain registered representatives would create their own, single shareholder corporation to receive the individual representative’s share of securities-based compensation.); Voluntary Benefit Systems Corporation of America (Nov. 14, 1995) (Dually registered insurance agent and registered representative of a broker-dealer requested and was denied no-action request where he requested that his commission compensation be directed to an existing life insurance agency not registered as a broker-dealer.); Lombard Securities Incorporated (July 12, 1994)(SEC denied no-action relief when it requested that it be able to direct securities-based compensation directly to “service corporation” rather than make such payments individually to each registered person. All owners of the “service corporation” were proposed to be registered as associated persons of a broker-dealer.); Vanasco, Wayne & Genelly (Feb. 17, 1999)(No Action request denied where registered representatives would continue to be employed by the broker-dealer, the broker-dealer would route all trading commissions earned by the registered representatives to their respective personal service corporations, rather than directly to the individual representatives.).
[iii] See Herbruck, Alder & Co. (May 3, 2002)(Firm denied no-action relief where all nine owners were registered representatives of a broker-dealer who would receive commission checks directly from broker-dealer, deposit them in their own personal accounts, and then write a check to the firm. The purpose of combining the revenues was that the firm could deduct “overhead, payroll taxes, and fringe benefit costs” and remit the balance to the employee(s).); Wolff Juall Investments, LLC (May 17, 2005)(No relief granted where registered representatives proposed to deposit their commissions with a limited liability corporation not registered as a broker-dealer to cover expenses with the non-registered entity to distribute the remainder to the registered representatives.); Birchtree Financial Services, Inc. (Sept. 22, 1998)(No Action Relief denied where Birchtree Financial Services requested the payment of commissions to an entity owned and operated solely by two registered representatives. Relief also denied for the assignment of commissions by the two registered representatives to an entity. The entity was created to pay operating expenses and health care benefits for employees.); Century Investment Group Incorporated (Jan. 29, 1996)(SEC Division of Market Regulation would not offer relief where certain registered representatives would create their own, single shareholder corporation to receive the individual representative’s share of securities-based compensation.); Voluntary Benefit Systems Corporation of America (Nov. 14, 1995) (Dually registered insurance agent and registered representative of a broker-dealer requested and was denied no-action request where he requested that his commission compensation be directed to an existing life insurance agency not registered as a broker-dealer.); Lombard Securities Incorporated (July 12, 1994)(SEC denied no-action relief when it requested that it be able to direct securities-based compensation directly to “service corporation” rather than make such payments individually to each registered person. All owners of the “service corporation” were proposed to be registered as associated persons of a broker-dealer.); Vanasco, Wayne & Genelly (Feb. 17, 1999)(No Action request denied where registered representatives would continue to be employed by the broker-dealer, and the broker-dealer would route all trading commissions earned by the registered representatives to their respective personal service corporations, rather than directly to the individual representatives.). But see, 1st Global, Inc. (May 7, 2001)(No action request partially denied and partially granted. 1st Global Capital Corp. was a registered broker-dealer. The firm had many registered representatives who were also partners in accounting firms. The SEC granted no-action relief where 1st Global Capital Corp. would pay securities commissions to a CPA registered representative who is not subject to a formal or informal agreement requiring him to turn securities commissions over to an unregistered CPA firm, and no unregistered person would be eligible to receive commissions directly or indirectly. However the SEC denied no-action relief where 1st Global Capital Corp. would pay securities commissions to a CPA registered representative, with the understanding that the registered representative would then “voluntarily” turn those commissions over to an unregistered CPA firm.)
[iv] Carey v. Bumstead (“Courts are not bound by the determinations made in SEC no-action letters, and the letters do not carry any precedential value. Apache Corp. v. Chevedden, 696 F. Supp. 2d 723, 735 (S.D. Tex. 2010). Nevertheless, regulatory interpretations in these letters may “enlighten a court struggling with ambiguous provisions in federal securities statutes or [SEC] rules.” Id. (quoting Donna M. Nagy, Judicial Reliance on Regulatory Interpretations in SEC No-Action Letters: Current Problems and a Proposed Framework, 83 CORNELL L. REV. 921, 996 (1998)). Thus, we consider the SEC no-action letters as persuasive authority. Id.; see also Cryl ex rel. Shire Pharm. Grp. PLC v. Shire Pharm. Grp. PLC, 298 F.3d 136, 145 (2d Cir. 2002). Based on these SEC no-action letters, it is highly likely the legal structure Bumstead and Carey created—assigning commissions to SFI to cover expenses and then having SFI pay any residual funds back to them—violated FINRA Rule 2040.”)