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Outside Business

Activities

A White Paper from the Financial Services Institute, Inc.

June 2017

1 financialservices.org The Financial Services Institute, Inc. (FSI) is the advocacy organization for independent broker-dealers (IBDs) and independent financial advisors. The independent financial services com munity has been an important and active part of the lives of American investors for more than 40 years. In the U.S., there are approximately 167,000 independent financial advisors who account for approximately 64.5% producing registered representatives. These financial advisors are self-employed independent contractors, rather than employees of their associated independent broker-dealers. FSI members make substantial contributions to our nation's economy. According to Oxford Economics, FSI members nationwide generate $48.3 billion of economic activity. This activity, in turn, supports 482,100 jobs including direct employees, those employed in the FSI supply chain and those supported in the broader economy. In addition, FSI members contribute nearly $6.8 billion annually to federal, state and local government taxes. FSI members account for approximately 8.4% of the total financial services industry contribution to U.S. economic activity. FSI's mission is to create a healthier regulatory environment for independent broker-dealers and their affiliated independent financial advisors through aggressive and effective advocacy, education and public awareness. FSI's advocacy efforts on behalf of our members include industry surveys, research and outreach to legislators, regulators and policymakers. FSI also provides our members with an appropriate forum to share benchmarks in an attempt to improve their compliance, operations and marketing efforts. We commend and appreciate the hard work, strong efforts and significant time committed to drafting this white paper by the members of FSI's Outside Business Activity Task Force. The Task

Force includes:

with this effort. Special thanks go to: Should you have any questions, or would like more information, please contact David Bellaire, 2 financialservices.org This publication is circulated to bring useful and timely information to FSI's members. The publication is for general informational purposes only and should not be considered legal state securities laws or represent best practices. You should not rely on any information or views contained in this white paper in evaluating any specific legal issues you may have. Please consult your attorney for specific legal advice. 3 financialservices.org

Table of Contents

I

Introduction

II. What are the benefits of OBAs?

III. What constitutes an outside business activity (OBA)? IV. What is the regulatory and compliance framework for OBAs? V. What are the consequences for failing to comply with OBA regulatory requirements VI. What practices have firms adopted with regard to OBAs? FAQs

Firm A

Firm B

Firm D

Firm E

Firm F

Firm I

Firm J

VII.

VIII. Appendix I

IX. Appendix II........................................................................ .......4 ...........................7 ......................................11 ..............................17 4 financialservices.org

I. Introduction

As securities markets and broker-dealers evolve to meet the needs of their clients, so do the compliance programs designed to protect clients and identify risk. One area where there has been recent innovation and development is outside business activities (OBAs). Both regulators and broker-dealer compliance officers have demonstrated a concentrated focus on OBAs, which are common among independent financial advisors. The IBD channel enables financial advisors to provide services to Main Street Americans, particularly in less populous or affluent communities. 1

According to the Oxford Economics Study

on the Economic Impact of FSI Members, FSI members have a more substantial impact in smaller states. 2 As a result, FSI members are found operating on main streets in small and mid-sized towns throughout the U.S. Often these advisors are the only financial experts in their community. Because of the unique relationship between independent advisors and their clients, many clients request and expect to be able to turn to their financial advisor for additional services such as insurance, accounting or other financial-related expertise that are outside the scope of the financial

advisor's securities license. OBAs provide clients with the convenience of receiving related services

from one professional whom they trust and who also has sophisticated knowledge of their entire decision-making concerning the approval of OBAs and firm efforts to monitor their advisors' activities in furtherance of the firm-approved OBA. The FSI Outside Business Activity Task Force was formed to review OBAs in the IBD channel. In composing this white paper, the OBA Task Force focused on the following questions:

What benefits do OBAs provide?

What constitutes an outside business activity?

What is the regulatory and compliance framework for OBAs? What are the consequences for failing to comply with OBA regulatory requirements? What practices have firms adopted with regard to OBAs?

II. What are the benefits of OBAs?

A. Why do financial advisors engage in OBAs?

Simply put, financial advisors engage in OBAs because it is often what their clients expect and need. This is particularly true for financial advisors who operate in sparsely populated or rural areas where a variety of professional services are not available to clients. Instead, clients need to work with a professional who can provide them everything they need in one stop. Additionally, independent financial advisors are small business owners. The ability for these advisors to operate 1 The use of the term "financial advisor" or "advisor" in this letter is a refer ence to an individual who is a registered representative

of a broker-dealer, an investment adviser representative of a registered investment adviser firm, or a dual registrant. The use

securities division as an investment adviser. 2

See Oxford Economics Study on the Economic Impact of FSI Members, available at http://www.financialservices.org/uploaded-

5 financialservices.org their business, pay their staff, and continue to provide crucial retirement and investment advice

to their clients is made possible by their ability to offer services outside their securities offerings.

These services enable independent financial advisors to hire and maintain their s taff from the local community. FSI members in particular benefit from being able to maintain a strong presence in their communities. According to the 2016 Oxford Economics Study of the Economic Impact of FSI members, FSI members support more than 482,000 jobs. 3

These firms directly support the

employment of more than 160,000 financial advisors and support staff. In addition, for each independent financial advisor directly affiliated with an FSI member fir m, a further two jobs are supported in the wider economy, either in the supply chains of FSI members or through the wage spending of those employed in the firms themselves or in their supply chains (in total 322,000 additional jobs in industries as diverse as professional services, restaurants and hospitality). 4 By engaging in OBAs, FSI members have enough financial flexibility to support their staff and local community.

B. How do OBAs benefit clients and the community?

Independent financial advisors engage in various OBAs because these services are often not independent financial advisors are typically 'main street Americans' who have tens and hundreds of thousands as opposed to millions of dollars to invest. Often, these financial advisors are the only provider of financial services and planning in their community." 5 Independent financial advisors share a unique relationship with their cl ients. Financial advisors,

their clients' overall financial situation. They have knowledge about their clients' holistic financial

profiles, allowing the financial advisor to understand the specific needs of each client. The ability

to provide holistic advice benefits clients by ensuring their financial plan is designed to achieve understanding of their current financial status provides the client additional confidence and comfort. Independent financial advisors are therefore in the best position to advise their clients, for example, on the tax implications of financial decisions or suitable insurance options to meet their needs. Often, these additional, crucial services are only available as OBAs from independent financial advisors. This is particularly true in rural or sparsely populated areas where insurance or accounting firms are not located. Independent financial advisors are uniquely situated to fill this gap because they are spread throughout the country where larger firms often do not conduct 3

See Oxford Economics Study on the Economic Impact of FSI Members, available at http://www.financialservices.org/uploaded-

4 Id. 5 6 financialservices.org business. OBAs are often essential to service the needs of clients in rural and sparsely populated communities who don't have the luxury of choosing from a multitude of qualified professionals. But clients in urban and suburban communities benefit from OBAs as well. Modern clients expect

efficiency in both service and cost, and OBAs fulfill this need by allowing a client multiple services

prefer to work with. Additionally, the local community benefits from a financial advisor's involvement in OBAs as well. The community benefits from tax revenues and jobs created by these small businesses. Advisors can even leverage their specialized financial expertise and OBAs to better serve local nonprofits and businesses by participating effectively on local nonprofit boards or by sharing their knowledge of the financial and other needs of the community. OBAs thus allow advisors to serve a vital role in their community and better serve its residents.

C. Potential Drawbacks of OBAs

enforcement actions that demonstrate there can also be several drawbacks if financial advisors involves advisors using their OBA to engage in selling away. Another common issue is investor

outside of their relationship with the firm. Investors might assume the business they conduct through

the OBA contains the same obligations and protections they enjoy with business conducted through the firm. III. What constitutes an outside business activity (OBA)? 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." 6 OBAs include many non-securities business activities which are conducted outside the scope of the

relationship a financial advisor has with their broker-dealer firm. These activities can include fixed

insurance sales, operating a registered investment adviser or providing additional services such as tax preparation, accounting support, bookkeeping or legal advice. An activity does not need to result in compensation to qualify as an OBA. OBAs can include non-compensated leadership positions a financial advisor holds such as being a president, treasurer, trustee or other position of a non-profit board of trustees. Firms decide, on an individual basis, which activities will be 6 7 financialservices.org approved, approved with limitations or restrictions, or denied. Identifying activities that meet with definition of OBA is the first step toward compliance. It is important that financial advisors, as well as IBD personnel, understand this definition and its implications. We discuss those implications in greater detail below. IV. What is the regulatory and compliance framework for OBAs?

A. What are the FINRA rules that govern OBAs?

FINRA Rule 3270 (Formerly NASD Rule 3030) - Outside Business Activities of Registered

Persons

or disapproval of the OBA, the majority of IBD firms have written supervisory procedures that require the financial advisor to inform them of the OBA and cease to undertake it until the firm approves or disapproves of the activity. Therefore, as a practical matter, once an IBD firm is informed of an OBA, they must determine if the activity is either: A permitted activity per the firm's written supervisory procedures,

An activity approved by the firm per their written supervisory procedures, but subject to specific conditions, or

An activity not permissible per the firm's written supervisory procedures resulting in the financial advisor barred by the firm from engaging in it under any circumstances.

consideration when evaluating whether to approve, impose specific conditions or deny the OBA Interfere with or otherwise compromise the registered person's responsibilities to the

Be viewed by the client 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,

7 or Be characterized as an outside business activity or whether it should be treate d as an 8 Firms should be mindful of these key considerations when they review proposed OBAs because once the activity is deemed permissible, the firm must provide ongoing monitoring of the OBA for compliance with any limitations. It may be helpful for firms to evaluate these activities from the perspective of the client. Firms should ask themselves if the client could perceive the activity as 7

Id at 1.

8 Id. 8 financialservices.org

being associated with the firm and, if the answer is "Yes," consider imposing restrictions or denying

the request to engage in the OBA. reminded financial advisors of their responsibility to report such activities to their firms. 9 to The notice reminded firms they should "review their supervisory and compliance procedures to make sure that their reporting requirements are clear and complete and that each associated person receives appropriate education and training regarding the sale of notes." You will find a 10 include in their WSPs the process, procedures, and standards under which they will evaluate proposed OBAs. It is also common and advisable for firms to include in their WSPs their process for evaluating whether the activity is an OBA or a PST. Firms must adequately outline their approval process, documentation, and monitoring of OBAs. Firms should also document and preserve their decision making process and any additional monitoring they conduct. For example, a firm's WSPs could require that it maintain and preserve: A written summary of the activities to be performed by the financial advisor; A written request from the financial advisor to engage in the outside business activity; and

A written response from the firm acknowledging the request and approving, limiting or denying the advisor's involvement with that activity.

sanctions of $2,500 to $73,000. 11 The severity of the fine is based on a review of the following: Whether the outside activity involved clients of the firm. Whether the outside activity resulted directly or indirectly in injury t o clients of the firm and, if so, the nature and extent of the injury. The duration of the outside activity, the number of clients and the dollar volume of sales.

Whether the respondent's marketing and sale of the product or service could have created the impression that the firm had approved the product or service.

Whether the respondent misled his or her firm about the existence of the outside activity or otherwise concealed the activity from the firm

The importance of the role played by the respondent in the OBA. 12 9 10 p038506.pdf. 11 12 Id. 9 financialservices.org business days to three months. longer suspension of up to one year. two years or a bar. 13 B. What other things should firms consider when reviewing OBA requests? There are some important additional concerns and considerations that firms should take into annual conferences regularly include panels on the subject of OBAs and PSTs that provide helpful information provided by industry panelists over the past couple of years suggests that firms would benefit from asking the following questions when reviewing OBAs:

Will the OBA confuse the client?

Will the OBA be confused with the broker-dealer business?

Is the OBA actually a PST?

Where will the OBA take place?

take in order to monitor potential changes in the activity?

Even if the role is an unpaid volunteer role, are the facts and circumstances such that the firm should be concerned about the activity?

Even if there is no compensation, does the expectation of compensation exist or might it exist in the future?

Does the role, whether paid or unpaid, involve access to funds (for example, a treasurer role)?

could it begin to require a larger time commitment, is there a possibility of PSTs going through the OBA, etc?

14 Industry panelists have also provided the helpful suggestions for firms to consider incorporating into their training and WSPs to ensure that they are properly identifying potential red flags and are on the lookout for additional undisclosed activities: Firms should not allow advisors to be mortgage brokers and sell reverse mortgages. 13 Id. 14 10 financialservices.org investigate whether the other named principals are clients. Firms should notice any lifestyle changes that do not fall in line with the advisor's earnings and investigate those changes by reviewing the advisor's tax records.

If a firm sees money coming to an advisor that is not related to the broker-dealer business the firm should inquire about it.

If the activity does not relate to the broker-dealer business and takes up a substantial portion of the advisor's time, it should not be approved.

Firms should use their secretary of state's website to see advisor's involvement with other companies.

Firms should occasionally look at Zillow to see the value of an advisor's home to ensure they are living within their means.

Firms should review a financial advisor's third party emails that come through the firm's server. Firms should periodically re-evaluate approved and denied activities.

Advisors must alert firms about the sale of their outside businesses. Depending upon relevant facts and circumstances, such sales of a business may constitute a PST. The firm should investigate the sale and conduct proper due diligence.

A firm's WSPs may also require OBA approvals to include express conditions that address any future documentation that will be required to demonstrate compliance with any limitations put in place.

A firm's WSPs may also address the time period in which the firm will review OBA requests. encourage firms to institute an internal minimum notice period.

expectations of firms.

C. Do OBAs need to be supervised by firms?

permit OBAs have a responsibility to appropriately and reasonably monitor those activities based recognizes that a member does not have the same supervisory responsibilities over a registered

person's outside non-securities activities as it does for his or her outside securities activities, a

member nevertheless has an important regulatory responsibility to evaluate the potential impact responsibility." 15 As a result, firms must respond appropriately to "red flags" that may indicate a failure to report an OBA accurately. In addition, if a firm denies a financial advisor's request to participate in an OBA, the firm must take reasonable steps to ensure that the financial advisor is

not engaging in the prohibited activity. Also, if a firm approves a financial advisor's participation

in an OBA but places restrictions or limitations on the activity or involvement, the firm must monitor

that the financial advisor adheres to those limitations and follow up on any red flags that could 15 http://www.lexolo- 11 financialservices.org indicate a failure to comply. This may be accomplished during a yearly branch office examination but can also be monitored in various other ways, such as review of correspondence, conversations with colleagues and simple observation by supervisory personnel. V. What are the consequences for failing to comply with OBA regulatory requirements?

A. FINRA Enforcement

1. Incorrectly treating conduct as n OBA instead of a private securities transaction

There is an important distinction between OBAs and PSTs. OBAs involve a non-securities business activity outside the role an advisor has with their firm. PSTs are "any securities transaction outside the regular course or scope of an associated person's employment with a member." 16 firm including both registered and non-registered persons. It is important for a firm to properly distinguish activities between the two due to the different oversight and monitoring requirements PSTs, no such requirement is contained in the OBA rule. Instead, firms have widely adopted the approval or disapproval process as part of their WSPs to ensure they properly examine the request and weigh the facts and circumstances thoroughly and consistently.

2. Failure to supervise for compliance with FINRA Rule 3280

17

For example, one firm conducted an

examination of the office of one of its financial advisors and discovered that the representative was recommending "managed accounts" and "alternative investments" through his outside investment fund as an OBA. The firm failed to adequately investigate these red flags, therefore failed to identify the failure to supervise the PSTs of 79 additional financial advisors registered with the firm because the firm treated their representatives' trading activities as OBAs rather than fined the firm $500,000 for this and other violations. In another case, a financial advisor disclosed to his firm that, as an OBA, he generated leads on the acquisition, development and marketing of natural gas. 18 company at conferences to develop qualified leads, making presentations about market trends for natural gas and oil, tax strategies for ownership of oil and gas, and the strategies that the 16 17 18 12 financialservices.org exploration and production company used to explore fossil fuels. For that work, he received both of its determination of whether his activities were properly reported as an OBA or whether they $8,500. 19

3. Failure to properly investigate red flags indicating a likely PST or fraud

resulting from an OBA disclosure. A financial advisor had disclosed an OBA as being formed for the purpose of "raising capital for investment in closely held businesses." The advisor stated that that an OBA disclosure of that nature should have raised "heightened scrutiny" to determine if for six months and fined him personally $5,000.quotesdbs_dbs14.pdfusesText_20

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