Is FINRA’s Proposed Rule Regarding Back-Office Personnel Too Broad?

The scandals involving Bernie Madoff, Tom Petters and others have inspired action from the Financial Industry Regulatory Authority (FINRA) - an independent regulatory body of securities firms in the United States.

As a reaction to the high-profile scandals, FINRA proposed a rule in May 2010 that would increase the amount of oversight in the securities industry. The proposed rule, which FINRA recently submitted to the Securities and Exchange Committee (SEC), would extend oversight to so-called "back-office" personnel, or operations professionals. Traditionally, only front-line professionals such as brokers, traders and investment bankers fell under the purview of FINRA and the SEC registration requirements.

Proposed Oversight

FINRA's proposed rule would require back-office professionals to register and be subject to examination and continuing education requirements. The examination, which is required prior to registration, would test the professional's general knowledge of the securities industry, regulatory requirements and ethics. Those that hold another industry license, such as a series 7, would be exempt from the examination requirement.

Covered Functions

The proposed rule, however, would not apply to all back-office employees, but only those positions that have decision-making and/or supervisory authority, ensuring that covered functions comply with all industry rules. The 15 covered functions FINRA lists in the proposed rule are:

  • Development and Approval of Pricing Models Used for Valuations
  • Trade Confirmation, Account Statements, Settlement or Margin
  • Stock Loan/Securities Lending
  • Prime Brokerage
  • Client Onboarding
  • Capturing of Business Requirements for Sales and Trading Systems and any other Systems Related to the Covered Functions, and Validation that these Statements Meet such Business Requirements
  • Defining and Approving Business Security Requirements and Policies for Information Technology Related to Covered Functions
  • Defining Information Entitlement Policy in Connection with Covered Functions
  • Financial Controller
  • Collection, Maintenance, Re-investment and Disbursement of Funds
  • Bank, Custody, Depository and Firm Account Management and Reconciliation
  • Segregation, Possession and Control, Fail Control or Buy-ins
  • Receipt and Delivery of Securities and Funds or Account Transfers
  • Financial Regulatory Reporting
  • Posting Entries to the Books and Records of a Firm in Connection with Covered Functions

Questions Raised by the Proposed Rule

While many may agree that extended oversight is necessary in light of the recent financial scandals, there are many within the securities industry that find the proposed rule to be overly broad and burdensome.

While non-supervisory personnel who perform covered functions for a firm would be exempt from the proposed FINRA rule, there is a very important exception to the covered function exemption - those that perform covered functions for third-party or affiliated firms on behalf of the firm. Meaning that when a firm outsources or has a parent or child company perform these tasks, those that perform the covered functions, regardless of supervisory or oversight duties, would be subject to FINRA's proposed rule.

It's this exception to the exemption that has many firms in the financial industry concerned. For instance, in its letter in response to the proposed FINRA rule, the financial firm Morgan Stanley expressed its concern that the rule would end up covering, "unnecessarily," mid-level employees of a "multi-layered" firm.

Specifically, Morgan Stanley's letter that the proposed rule's possible coverage of mid- and lower-level professionals would not further FINRA's stated goal of overseeing job functions that "have a meaningful connection to the client funds, accounts, and transactions." As such, it is speculated that technology professionals would fall under the auspices of the proposed rule. An article published in Investment News quotes Lisa Roth of Keystone Capital Corp. as speculating that a receptionist of a smaller firm, because of the multiple duties possibly assigned to that position, would be covered by the proposed rule.

Another concern, raised by the law firm Arnold & Porter in a letter to FINRA, is that the proposed rule may require employees of foreign firms to comply with the FINRA regulation in the United States. Say a firm works with a foreign firm to assist in the performance of covered functions, those who perform the covered functions, according to the proposed rule, may be subject to the FINRA rule even though they are foreign nationals working for a foreign firm in a foreign country. The letter raises the question of the necessity of this coverage when the back-office work performed elsewhere is overseen by a U.S. firm that would be responsible for the work performed.

While securities industry firms may raise concerns over the broadness of FINRA's proposed rule, one thing is certain, the misconduct of Mr. Madoff and Mr. Petters, which arguably involved back-office personnel, requires that action be taken. Investors with concerns about the conduct of a securities firm are encouraged to speak with a securities arbitration attorney about their situation.

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