JDSupra (February 13, 2024) By Christopher Grobbel, Peter LaVigne, Nicholas Losurdo Goodwin

Firms will be able to treat private residences from which certain supervisory activity is conducted as non-branch offices instead of OSJs. The adoption comes after nearly two years of FINRA efforts to align its supervisory rules with current work-from-home practices, despite significant pushback from the North American Securities Administrators Association, the Public Investors Advocate Bar Association, and other key industry groups arguing that permitting remote supervision would undermine investor protection.

Overview

On January 23, 2024, FINRA announced several updates to FINRA Rule 3110 (Supervision), including a measure to enable firms to treat a private residence as a non-branch Residential Supervisory Location (RSL), even if specified supervisory activities are conducted there. The permissible supervisory activity largely tracks that which is specified in the office of supervisory jurisdiction (OSJ) definition in FINRA Rule 3110(f) (including related approval of retail communications). Today, such a location would be an OSJ. RSL activity must, for the most part, fit within the existing Rule 3110 guardrails for private residence non-branch office locations. For example, no customer funds or securities could be handled at the location, and no customer meetings or sales activity could take place at the location. A separate rule introduces the Remote Inspection Pilot Program, which we will cover in a separate alert.

The key benefit for firms to designate an RSL will be that it’s treated as a non-branch location for purposes of inspection requirements. As a non-branch location, the RSL will be subject to periodic inspections, presumed to be at least every three years, rather than the annual inspections currently required for OSJs and supervisory branch offices.

Key Requirements and Risk Assessment

The rule is fairly prescriptive, with requirements related to location eligibility, and specific prohibitions that make some firms or locations ineligible. Firms that designate a residential location as an RSL must, prior to making such designation, design a reasonable risk-based approach to making such designations, conduct a risk assessment for the associated person assigned to the location, and document key factors of their risk assessment. In making their risk assessments, firms must document the factors considered, including:

  • Whether the associated person at the location is subject to customer complaints, taking into account the volume and nature of the complaints
  • Whether a heightened supervision plan is in effect (note that heightened supervision imposed by the SEC, FINRA, or a state makes a firm ineligible for RSLs, but firms should still consider whether any firm-imposed heightened supervision is in place)
  • Any failure to comply with the firm’s written supervisory procedures
  • Any recordkeeping violations
  • Any regulatory communications from FINRA, the SEC, or a securities regulator indicating that the associated person at such office or location failed to reasonably supervise another person subject to their supervision (e.g., subpoenas, preliminary or routine regulatory inquiries or requests for information, deficiency letters, “blue sheet” requests or other trading questionnaires, or examinations)

By the plain text of the rule, it does not specify whether a finding of a failure to comply with a firm’s written supervisory procedures or a recordkeeping violation must be an official finding (i.e., by a regulator via regulatory action). Firms should be specific about accounting for these factors in their risk assessments, including if a violation was discovered by an internal review. Firms are required to take into account any higher-risk activities that take place or a higher-risk associated person who is assigned to that office or location. Supervisory systems must also take into consideration any indicators of irregularities or misconduct (i.e., red flags), review red flags, and document steps taken to address red flags where applicable.

Eligibility

The following conditions must be satisfied for a private residence to be eligible for RSL designation:

  • Only one associated person, or multiple associated persons who reside at that location and are members of the same immediate family, conducts or conduct business at the location.
  • The location is not held out to the public as an office, and the associated person does not meet with customers or prospective customers at the location.
  • Either the primary residence is used for securities business for fewer than 30 business days in any one calendar year or any sales activity that takes place at the location complies with the conditions set forth under Rule 3110(f)(2)(A)(ii) (which are largely duplicative of the standards set forth here).
  • Neither customer funds nor securities are handled at that location.
  • The associated person is assigned to a designated branch office, and such designated branch office is reflected on all business cards, stationery, retail communications, and other communications to the public by such associated person.
  • The associated person’s correspondence and communications with the public are subject to the firm’s supervision in accordance with Rule 3110.
  • The associated person’s electronic communications are made through the member’s electronic system (presumably, this would preclude communication through a personal device at the RSL, unless such device was connected to the member’s electronic system).
  • The member has a compliant recordkeeping system in place, such records are not physically or electronically maintained and preserved at the RSL, and the member has prompt access to such records.
  • The firm determines that its surveillance and technology tools are appropriate to supervise the types of risks presented by each RSL.1

Firm Ineligibility

Firms will be ineligible to designate an office or location as an RSL under certain circumstances, including if the firm:

  • Is a new FINRA member within the prior 12 months
  • Has been found within the past three years by the SEC or FINRA to have violated Rule 3110(c)
  • Is currently undergoing, or is required to undergo, a review under Rule 1017(a)(7) as a result of one or more associated persons at such location
  • Is currently designated as a Restricted Firm under Rule 4111 or as a Taping Firm under Rule 3170

Location Ineligibility

A residence will be ineligible for designation as an RSL under certain circumstances, including if one or more associated persons at the location:

  • Is a designated supervisor who has less than one year of direct supervisory experience with the member or an affiliated broker-dealer or investment adviser
  • Is functioning as a principal for a limited period in accordance with Rule 1210.04
  • Is subject to a mandatory heightened supervisory plan under the rules of the SEC, FINRA, or a state agency; is statutorily disqualified (subject to certain exemptions) or has certain event disclosures on Form U4 within the prior three years; or has been notified in writing that such associated person is subject to certain regulatory investigations expressly alleging the person has failed reasonably to supervise another person subject to their supervision2

Notice to FINRA

A firm that elects to designate any of its offices or locations as RSLs must provide FINRA with a current list of such locations by the 15th day of the month following each calendar quarter. Firms may start using the RSL designation on June 1, 2024, and a firm’s first RSL list is due to FINRA on October 15, 2024, which would cover all locations that firms designate as RSLs during the period June 1, 2024, through September 30, 2024. FINRA is developing a process within the FINRA Gateway that will allow firms to identify RSLs and provide their quarterly RSL lists to FINRA.

Other Considerations and Requirements

Firms should be mindful of other obligations when considering RSLs. For example, any increase in the number of office locations could implicate a continuing membership application (e.g., if the increase does not fit within the IM-1011-1 safe harbor for business expansion, including due to the number of offices added or disciplinary history). In such cases, firms should consider whether the increase in offices is “material,” thus triggering Continuing Membership Application obligations.

Conclusion

Spurred by the pandemic, of all things, the new RSL designation offers firms greater flexibility in tailoring their branch and non-branch location supervisory structures, but not without the prescriptiveness firms are used to seeing from the regulator. Firms seeking to designate an RSL will need to consider eligibility requirements closely, develop and implement policies and procedures designed to comply with the requirements, and provide specified information to FINRA in a timely manner, among other requirements. Firms that successfully navigate these requirements should enjoy the added flexibility the new RSL program offers. At the same time as the RSL rule filing, FINRA adopted a voluntary three-year remote inspections pilot program to allow eligible member firms to fulfill their Rule 3110(c)(1) obligation to inspect qualified branch offices, including OSJs and non-branch locations, remotely, without an on-site visit to such offices or locations, subject to specified terms. We will cover that in a separate client alert.

[1] The tools may include but are not limited to: (i) firmwide tools such as electronic recordkeeping system; electronic surveillance of e-mail and correspondence; electronic trade blotters; regular activity-based sampling reviews; and tools for visual inspections; (ii) tools specific to the RSL based on the activities of the associated person assigned to the location, products offered, restrictions on the activity of the RSL; and (iii) system tools such as secure network connections and effective cybersecurity protocols.
[2] Such office or location may be designated or redesignated as an RSL upon the earlier of: (i) the member’s receipt of written notification from the applicable regulator that such investigation has concluded without further action; or (ii) one year from the date of the last communication from such regulator relating to such investigation.