Sales Supervision, General Supervision of Employees, Regulatory Framework of FINRA
Sales Supervision of DPP Offerings
The core supervisory question
Before a DPP order is accepted, the supervisor must answer one question: can this customer afford to lose this money and wait for it? The tools are Rule 2090 (know your customer), Rule 2111 (reasonable-basis, customer-specific and quantitative suitability), and Rule 2310, which bars member participation unless the firm has reasonable grounds to believe the customer can realize the program's benefits and has net worth sufficient to sustain the risks, including loss of principal and lack of liquidity.
Building the file
Document investment objectives, tax bracket, other investments, liquid net worth, risk tolerance and the source of funds. Note the special rule for non-traded REITs: aggregate investment may not exceed 10% of liquid net worth, counting the customer's other non-traded REIT positions. General DPPs carry no fixed percentage in Rule 2310, though many firms and states apply a similar 10% guideline - a classic trap.
Communications and conflicts
Retail communications need principal approval before use under Rule 2210, must be fair and balanced, and may not project investment results or promise that tax benefits will be realized. Disclose the general partner's multiple compensation streams and any affiliation between the member and the issuer; where the member is affiliated with the issuer, Rule 5121 may require a qualified independent underwriter. Non-cash compensation arrangements must comply with applicable rules and be disclosed.
Worked example
A retired customer with $400,000 liquid net worth wants $60,000 of a non-traded REIT. Ten percent of liquid net worth is $40,000, so the order must be cut to $40,000 or less - and any existing non-traded REIT holdings count toward that ceiling. The principal should document the adjustment in the file.
General Supervision of Employees
The supervisory system
FINRA Rule 3110 requires written supervisory procedures, designated supervisors, and a system reasonably designed to achieve compliance. Every associated person must be registered on Form U4, fingerprinted, and qualified for the products sold. Continuing education has two parts: the Firm Element (firm-designed, at least annually) and the Regulatory Element (securities-industry required, triggered by registration anniversaries). An annual compliance meeting is required.
Offices, communications and reports
Offices of supervisory jurisdiction are inspected at least annually; other branch offices at least every three years. Correspondence and internal communications must be reviewed by principal or spot-check. Firms must maintain exception reports and act on red flags.
Outside activities - the classic failure
Rule 3270 requires prior written notice of outside business activities. Rule 3280 requires prior written notice of private securities transactions; the firm must approve or disapprove in writing, and approved participation is recorded and supervised. Selling away is the most common DPP supervision failure. Also watch Rule 3220 (gift limit of $100 per year per person), Rule 3240 (borrowing from or lending to customers), Rule 4530 (reporting of certain events), Rule 3120 (annual certification of the supervisory control system), and Rule 3130 (CEO certification of compliance processes).
Worked example
A registered representative wants to sell interests in a private oil-and-gas program to three of her customers through an outside entity. She must give prior written notice; the firm may approve (with compensation and supervision recorded) or disapprove. If disapproved, she may not participate at all, even without compensation.
Regulatory Framework of FINRA
What FINRA is
FINRA is a self-regulatory organization overseen by the SEC. It writes and enforces rules through its By-Laws and rulebook, and material rule changes require SEC approval. FINRA may censure, fine, suspend, bar or expel members and associated persons, but it cannot prosecute crimes; criminal matters go to the Department of Justice. FINRA also enforces the federal securities laws and the rules of the MSRB.
Reading the rulebook
Know the series: 1000 (membership), 2000 (conduct), 3000 (supervision), 4000 (financial and operational), 5000 (offerings, including 5110 corporate financing and 5121 conflicts), 6000 (quotations), 8000 (investigations), 9000 (code of procedure), 12000 (arbitration), 13000 (mediation). Core conduct rules: 2010 standards of commercial honor, 2020 use of manipulative or deceptive devices, 2090 know your customer, 2111 suitability, 2210 communications, 3110 supervision, 4370 business continuity, 4511 books and records.
Enforcement mechanics
Rule 8210 lets FINRA compel testimony and documents; failure to respond is itself a violation. Disciplinary cases begin with the Department of Enforcement, proceed to a hearing panel, and may be appealed to the National Adjudicatory Council, then the SEC, then a federal court. Expedited proceedings exist for serious financial or operational problems.
Traps and a rule of thumb
Candidates confuse the arbitration code with the disciplinary code, and forget Rule 2010's catch-all reach - conduct need not violate a specific rule to be sanctionable. Rule of thumb: if a practice is deceptive or unfair but no numbered rule obviously fits, Rule 2010 applies.