FINRA Rule 2040 Explained: Payments to Unregistered Persons
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Interested in understanding FINRA Rule 2040? This comprehensive guide provides a detailed explanation of FINRA Rule 2040, which governs payments to unregistered persons in the securities industry.
By reading this page, you'll discover the general restrictions on payments, exceptions for retiring representatives, and conditions under which non-registered foreign finders can be compensated. Additionally, you'll learn about the necessary compliance measures that adhere to federal securities laws.
Whether you're new to the financial industry or a seasoned professional, this guide will assist you in understanding the complexities of FINRA Rule 2040 and help you move toward compliant payment practices.
InnReg is a global regulatory compliance and operations consulting team serving financial services companies since 2013. If you need assistance with compliance or fintech regulations, click here.
What Is FINRA Rule 2040?
FINRA Rule 2040 addresses the regulations surrounding payments to unregistered persons in the securities industry. The rule aims to ensure that all compensation practices comply with federal securities laws and maintain the integrity of the financial markets.
Here’s a comprehensive explanation of the rule’s key components:
General Prohibitions on Payments
FINRA Rule 2040 broadly prohibits members or associated persons from making payments to unregistered persons under two main conditions:
Unregistered Broker-Dealers: Payments cannot be made to individuals or entities that should be registered as broker-dealers under Section 15(a) of the Securities Exchange Act of 1934 but are not. This means any person or entity receiving such payments must be appropriately registered if their activities require it.
Compliance with Laws and Regulations: Payments to registered associated persons must comply with all applicable federal securities laws, FINRA rules, and SEC regulations.
Retiring Representatives
The rule allows for the payment of continuing commissions to retiring registered representatives under specific conditions:
Bona Fide Contract: The member firm must have a genuine contract in place with the retiring representative. This contract must have been made in good faith while the individual was still registered and must prohibit the retiring representative from soliciting new business, opening new accounts, or servicing existing accounts.
Compliance with Laws: The arrangement must comply with applicable federal securities laws and regulations.
A “retiring registered representative” is defined as someone who retires and leaves the securities industry, including those who retire due to total disability. In the event of the representative’s death, the contract’s designated beneficiary or the representative’s estate may receive the continuing commissions.
Non-registered Foreign Finders
FINRA Rule 2040 permits payments to non-registered foreign finders under specific conditions:
Assurance of Non-Registration Requirement: The member firm must assure itself that the foreign finder does not need to register as a broker-dealer in the United States and is not subject to disqualification under FINRA’s By-Laws. Additionally, the compensation arrangement must not violate any applicable foreign laws.
Foreign Status: The finder must be a foreign national or foreign entity based abroad, and the customers referred must also be foreign nationals or entities domiciled abroad transacting business in either foreign or US Securities.
Disclosure to Customers: Customers must receive a document disclosing the compensation arrangement with the finder, similar to the disclosure required under Rule 206(4)-3(b) of the Investment Advisers Act.
Customer Acknowledgment: Customers must provide written acknowledgment of the compensation arrangement, which the member firm must retain for inspection.
Recordkeeping: The member firm must maintain records of payments to finders and have the actual agreements available for FINRA inspection.
Transaction Confirmation: Each transaction confirmation must indicate that a referral or finder’s fee is being paid as per the agreement.
Compliance Support
To ensure compliance with Section 15(a) of the Exchange Act, members are expected to have reasonable support to determine that their activities do not require the recipient to register as a broker-dealer. Compliance support can be achieved by:
Relying on previously published releases, no-action letters, or SEC interpretations relevant to their situation.
Seeking a no-action letter from the SEC staff.
Obtaining a legal opinion from reputable, independent US counsel knowledgeable in this area.
These measures help firms ensure that their compensation practices do not inadvertently violate federal securities laws.
By understanding and adhering to these provisions, firms can align their payment practices with FINRA Rule 2040, thereby maintaining regulatory compliance and the integrity of the securities industry.
New Rule Exempts Certain M&A Brokers from Registration
Effective March 29, 2023, Section 15(b)(13) was added to the Securities and Exchange Act of 1934 and exempts M&A brokers from the registration requirement, thus allowing broker-dealers to pay these entities securities-based compensation.
It is important to note that the new rule excludes certain activities that would require an M&A broker to be registered. For example, an M&A broker that transmits securities in exchange for ownership of an eligible privately held company would be ineligible for the exemption and would have to register.
Insight from the Experts
"FINRA Rule 2040 is important for making sure only qualified, registered individuals receive compensation in the securities industry. This protects investors and maintains market standards. Firms must verify compliance to avoid regulatory issues."
What Is the Purpose of Rule 2040?
FINRA Rule 2040 is designed to maintain the integrity and transparency of compensation practices within the securities industry.
Its primary purpose is to ensure that only properly registered individuals receive payments related to securities transactions, thereby safeguarding investors and upholding industry standards.
Key objectives of Rule 2040 include:
Prevent Unregistered Activity:
The rule prohibits compensating unregistered persons who should be registered under federal securities laws. This helps prevent unqualified individuals from participating in securities transactions, reducing the risk of misconduct and fraud.
Regulate Continuing Commissions:
Rule 2040 allows firms to pay continuing commissions to retired representatives, provided specific conditions are met. This ensures that retiring representatives can still receive income from their past efforts without actively engaging in new business or violating regulatory standards.
Control Payments to Foreign Finders:
The rule permits payments to non-registered foreign finders under stringent conditions. This allows firms to benefit from international business while ensuring these arrangements comply with both US and foreign laws, protecting against illegal activities and maintaining global regulatory harmony.
Clarify Compliance Requirements:
By setting clear guidelines on compensation practices, Rule 2040 helps firms understand their obligations and maintain accurate records. This clarity supports better regulatory compliance and facilitates oversight by FINRA, contributing to a fair and orderly market.
Example 1
Payment to a Retiring Representative
Alex, a registered representative, retires after 25 years. His firm continues to pay him commissions from his existing client accounts based on a pre-established contract. This arrangement complies with Rule 2040 as long as John does not solicit new business or service the accounts post-retirement.
Example 2
Compensation to a Foreign Finder
A US brokerage firm collaborates with Maria, a foreign national, to refer foreign clients. The firm pays Maria transaction-related compensation, ensuring she is not required to register as a broker-dealer in the US and that all clients and transactions meet the conditions outlined in Rule 2040.
Note: The practical examples are fictional and created solely to enhance understanding of FINRA Rule 1210. They are not based on actual events or individuals and should not be interpreted as real-life scenarios.
FINRA Rule 2040 Violations and Cases
Understanding how FINRA Rule 2040 is applied in real-world situations can provide valuable insights into compliance and regulatory expectations. Below are examples of violations and cases that illustrate the consequences of non-compliance and the importance of adhering to the rule's requirements.
01
Informal Agreement Violation by Registered Representative
A registered representative violated FINRA Rules 2040 and 2010 by paying $27,037 in commissions to an unregistered individual from December 2017 to March 2018.
These payments were related to the representative's informal agreement to purchase the unregistered individual's book of business following their termination from a major financial firm for policy violations. The registered representative, who has been registered since 1999, managed the unregistered individual's accounts and negotiated to purchase their clients despite knowing that the firm’s policies prohibited such payments without a formal contract.
An internal investigation revealed these unauthorized payments, leading to the representative’s violation of the rules prohibiting compensating unregistered persons and mandating high standards of commercial honor. Consequently, the representative was fined $2,000, suspended for ten business days, and ordered to pay hearing costs of $5,565.38.
02
Unauthorized Compensation by Broker-Dealer and RIA
A full-service broker-dealer who had been a registered investment advisor and FINRA member since 1972 violated FINRA Rules 2040 and 2010 by paying approximately $19.3 million in transaction-based compensation to unregistered entities between January 2017 and January 2021.
The unregistered entities, set up by the firm's registered representatives, received these payments instead of the representatives themselves. Consequently, the firm was censured, fined $75,000, and required to certify that all its commission and payment arrangements comply with FINRA Rule 2040.
Insight from the Experts
"Allowing continuing commissions for retiring representatives under Rule 2040 highlights the need for compliant succession planning. This supports financial security for retirees and a smooth transition for clients while maintaining regulatory compliance."
Frequently Asked Questions About FINRA's Payments to Unregistered Persons Rule
Understanding how FINRA Rule 2040 is applied in real-world situations can provide valuable insights into compliance and regulatory expectations. Below are examples of violations and cases that illustrate the consequences of non-compliance and the importance of adhering to the rule's requirements.
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