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Approved Outside Business Activity Morphs Into A Troubling Private Securities Transaction
April 27, 2016
In addition to your career as a stockbroker, you decided to start up an outside business. As a registered representative with a FINRA member firm, you understand that prior to embarking upon that so-called outside business activity, you're required to provide your firm with prior written notice, which you did. Good for you! Later on, you decide to seek an investor. Luckily you find someone and the two of you agree to terms. A check is written and cashed. Stock is issued. Ummmm . . . did you forget something?
Case In Point
For the purpose of proposing a settlement of rule violations alleged by the Financial Industry Regulatory Authority ("FINRA"), without admitting or denying the findings, prior to a regulatory hearing, and without an adjudication of any issue, Jeffrey C. Borneman submitted a Letter of Acceptance, Waiver and Consent ("AWC"), which FINRA accepted. In the Matter of Jeffrey C. Borneman, Respondent (AWC 2015044368901, April 22, 2016).
Borneman was first registered in 2000, and from that date through January 2015, the AWC asserts that he was registered with five FINRA member firms. By 2014, Borneman was registered with Cambridge Investment until his February 4, 2015, termination. The AWC asserts that Borneman had no prior relevant disciplinary history.
Forming the LLC (the OBA)
While registered with Cambridge in January 2015, Borneman purportedly formed a Limited Liability Company ("LLC") for the purpose of publicizing general market and industry analysis. The AWC confirms that Cambridge approved the LLC as an outside business activity ("OBA"). Thereafter, Borneman owned and operated the LLC as an approved OBA.
SIDE BAR: So far, so good. In accordance with FINRA Rule 3270, Borneman provided prior written notice to Cambridge about his intention to engage in an OBA in the form of the LLC.
FINRA Conduct Rule 3270: Outside Business Activities of Registered PersonsNo registered person may be an employee, independent contractor, sole proprietor, officer, director or partner of another person, or be compensated, or have the reasonable expectation of compensation, from any other person as a result of any business activity outside the scope of the relationship with his or her member firm, unless he or she has provided prior written notice to the member, in such form as specified by the member. Passive investments and activities subject to the requirements of NASD Rule 3040 shall be exempted from this requirement.***Supplemental Material***.01 Obligations of Member Receiving Notice. Upon receipt of a written notice under Rule 3270, a member shall consider whether the proposed activity will: (1) interfere with or otherwise compromise the registered person's responsibilities to the member and/or the member's customers or (2) be viewed by customers or the public as part of the member's business based upon, among other factors, the nature of the proposed activity and the manner in which it will be offered. Based on the member's review of such factors, the member must evaluate the advisability of imposing specific conditions or limitations on a registered person's outside business activity, including where circumstances warrant, prohibiting the activity. A member also must evaluate the proposed activity to determine whether the activity properly is characterized as an outside business activity or whether it should be treated as an outside securities activity subject to the requirements of NASD Rule 3040. A member must keep a record of its compliance with these obligations with respect to each written notice received and must preserve this record for the period of time and accessibility specified in SEA Rule 17a-4(e)(1).
Selling Stock (the PST)
In March 2014, Borneman purportedly sold for $15,000 a 5% interest in his LLC to one of his Cambridge customers. The sale was memorialized in the form of a stock certificate and the purchasing customer allegedly deemed the transaction be constitute an investment.
The AWC asserts that the sale was undertaken without prior written notice from Borneman to Cambridge, and, accordingly, FINRA deemed the subject sale to constitute a private securities transaction ("PST") in violation of NASD Rule 3040: Private Securities Transactions of An Associate Person, and FINRA Rule 2010.
SIDE BAR: Ooops! Having complied with the notice obligations for the OBA, Borneman failed to comply with the prior notice requirements of FINRA's PST Rule. An outside business activity and a private securities transaction may, indeed, involve the same underlying business but you still need to submit two different notices under FINRA's regulatory scheme. Apparently, Borneman failed to submit any written notice of the PST. Although a member firm's "approval" is not contemplated in the OBA Rule, that is not the case for the PST Rule when the transaction involves compensation:
(c) Transactions for Compensation(1) In the case of a transaction in which an associated person has received or may receive selling compensation, a member which has received notice pursuant to paragraph (b) shall advise the associated person in writing stating whether the member:
(A) approves the person's participation in the proposed transaction; or(B) disapproves the person's participation in the proposed transaction.
(2) If the member approves a person's participation in a transaction pursuant toparagraph (c)(1), the transaction shall be recorded on the books and records of the member and the member shall supervise the person's participation in the transaction as if the transaction were executed on behalf of the member.(3) If the member disapproves a person's participation pursuant to paragraph (c)(1), the person shall not participate in the transaction in any manner, directly or indirectly.
Permitted to Resign
Online FINRA BrokerCheck records as of April 27, 2016, disclosed that Cambridge permitted Borneman to resign on January 6, 2015, amid allegations that
RR ENGAGED IN A PRIVATE SECURITIES TRANSACTION WITH CLIENT WITHOUT RECEIVING APPROVAL FROM THE FIRM. THE FIRM WOULD NOT HAVE OTHERWISE PARTICIPATED IN THIS TRANSACTION, AND THERE IS NO INDICATION CLIENT FUNDS HELD BY THE FIRM WERE USED FOR THE TRANSACTION. THERE IS NO INDICATION RR RECEIVED ANY SELLING COMPENSATION FOR THE TRANSACTION.
FINRA Sanctions
In accordance with the terms of the AWC, FINRA imposed upon Borneman a $5,000 fine and a 30-day suspension from association with any FINRA member in any capacity.
Bill Singer's Comment
FINRA did not charge Borneman with receiving selling compensation but only cited him for failing to undertake prior written disclosure of the PST to Cambridge. In that regard, keep in mind Cambridge's BrokerCheck comment that "There is no indication RR received any selling compensation for the transaction." Notwithstanding Cambridge's conclusion, consider the operable definition in FINRA Rule 3040:
(2) "Selling compensation" shall mean any compensation paid directly or indirectly fromwhatever source in connection with or as a result of the purchase or sale of a security,including, though not limited to, commissions; finder's fees; securities or rights toacquire securities; rights of participation in profits, tax benefits, or dissolution proceeds, as a general partner or otherwise; or expense reimbursements.
In defining "selling compensation," the PST Rule offers a list of examples that are predicated by the admonition that such forms of compensation as commissions, finder's fees, etc. are "including, though not limited to." Sometimes definitions are not so definitive and what we intuitively think is correct may not hold up under a regulator's scrutiny.
Solely going by the AWC's fact pattern,Borneman did not receive a direct commission or fee attendant to the sale; however, what about the so-called "indirect" compensation referenced in the Rule? For example, what if Borneman was the sole owner of the LLC prior to the 5% sale -- would that impact the analysis of whether said sale contained an indirect form of selling compensation? If you were an in-house compliance officer, what information would you have requested from a registered person such as Borneman in order to determine whether the sale included direct or indirect selling compensation? Although that last question is posed in a rhetorical fashion, I would urge all compliance staff to give it some thought and to discuss the issue within the firm.
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