Friday, April 22, 2011


NASD Rule 3040 regarding Private Securities Transactions of Associated Persons has been around since 1985. NASD issued Notices to Members on the subject in 1985, 1991, 1994, 1996, 2001 and 2003. The title to the 2001 Notice was: “NASD Reminds Members of their Responsibilities Regarding Private Securities Transactions Involving Notes and Other Securities and Outside Business Activities.” In 2002, a law firm issued a “Client Memorandum” entitled “Be Alert: Regulators are Keeping a Watchful Eye on Outside Business Activities.” Notably, the memorandum began by stating: “Selling away and outside business activities have become hot topics for regulators. The NASD, in particular, has brought numerous formal disciplinary actions...”

Perhaps things really do stay the same the more they change. Earlier this month FINRA issued a news release about sanctions it levied against two firms and several registered representatives that failed to satisfy the mandates of Rule 3040.

On its face, Rule 3040 doesn't appear to be particularly complicated. But its compliance has been eluding industry members for over two decades now.

Rule 3040 requires an associated person to provide written notice to its FINRA member “describing in detail the proposed transaction and the person’s proposed role therein” when the person will be receiving “any compensation paid directly or indirectly from whatever source in connection with or as a result of the purchase or sale of a security.” The rule defines a “private security transaction.” Once the member receives the written notice, it can either deny approval of the associated person's proposed participation, or, if it approves: “[record] the transaction...on the books and records of the member and...supervise the person's participation in the transaction as if the transaction were executed on behalf of the member.”

Despite the rule's clear mandate, FINRA's recent enforcement actions demonstrate that associated persons continue to forge ahead on private placements without getting permission from their member firm, and members continue to punt on their due diligence obligations before they give approval in response to a request. That due diligence obligation requires the broker-dealer to perform both a client-specific and reasonable-basis suitability analysis. The latter requires a reasonable investigation of the sale of the private transaction or placement. And simply relying upon information provided by the issuer of the security does not pass the muster as a “reasonable investigation.”

FINRA's news release provides additional details regarding the individual’s sanctioned for their participation in the sale of placements offered by Medical Capital Holdings and Provident Royalties, LLC and the firms for their lack of due diligence on these two placements, as well as those issued by DBSI, Inc. According to FINRA: “without performing proper due diligence, the firms could not identify and understand the inherent risks of these offerings.” Considering the multitude of firms that peddled DBSI notes and TICs in apparent oblivion of Rule 3040, one can surely anticipate future enforcement actions in this area.

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