6.4 Referral Payments, Bank Networking, and Unregistered Persons

FINRA Rule 2040: Payments to Unregistered Persons

FINRA Rule 2040(a) prohibits a member or associated person from directly or indirectly paying any compensation, fees, concessions, discounts, commissions or other allowances to:

1. any person that is not registered as a broker-dealer under Exchange Act Section 15(a) but, because of receiving the payment and the related activities, would be required to register; or
2. any appropriately registered associated person unless the payment complies with the federal securities laws, FINRA rules and SEC rules.

The test is whether the recipient's activity, together with the payment, is broker activity. Transaction-based compensation, meaning payment that depends on whether a securities transaction occurs or how large it is, is the classic indicator. Rule 2040.01 expects members to determine, and reasonably support, that a payment would not require the recipient to register. Support can come from reasonable reliance on SEC releases, no-action letters or staff interpretations that fit the facts, a no-action letter the member obtains, or an opinion from independent, reputable U.S. counsel. The determination must be documented and reviewed periodically if payments are ongoing.

Unregistered Referral Fees

A registered representative cannot agree to pay a real estate agent, tax preparer or mortgage broker a share of mutual fund commissions for referring clients. Calling the payment a "consulting fee" does not change its character, and a private payment would also bypass the firm's books and records.

Continuing Commissions to Retiring Representatives (Rule 2040(b))

A member may pay continuing commissions to a retiring registered representative after the person stops being associated with the member, derived from accounts held for the representative's continuing customers, even if customers add funds or securities during the retirement period, provided that:

1. a bona fide contract providing for the payments was entered into in good faith while the person was a registered representative of the member;
2. the contract prohibits the retiring representative from soliciting new business, opening new accounts, or servicing the accounts that generate the payments; and
3. the arrangement complies with the federal securities laws and SEC rules.

A "retiring registered representative" retires from a member, including because of total disability, and leaves the securities industry. If the person dies, the beneficiary named in the contract, or the estate if none is named, may receive the payments.

Foreign Finders (Rule 2040(c))

A member may pay transaction-related compensation to a nonregistered foreign finder who directs customers to the member only if:

• the member has assured itself that the finder is not required to register in the United States as a broker-dealer, is not subject to a disqualification under FINRA's By-Laws, and that the arrangement does not violate foreign law;
• the finder is a foreign national (not a U.S. citizen) or a foreign entity domiciled abroad;
• the customers are foreign nationals or foreign entities domiciled abroad;
• customers receive a descriptive document disclosing the compensation paid to finders and give the member a written acknowledgment of the arrangement, which is retained for FINRA;
• the member records the payments on its books and keeps the finder agreements available for inspection; and
• each confirmation states that a referral or finder's fee is being paid under an agreement.

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FINRA Rule 3160: Networking Arrangements with Financial Institutions

Many broker-dealers offer services at banks and credit unions through networking arrangements. Because bank customers associate the setting with deposit insurance, FINRA Rule 3160 requires safeguards against confusion between deposits and uninsured securities products.

Setting, Agreement and Identification

• The member must be clearly identified as the provider of broker-dealer services and must distinguish its services from the financial institution's.
• To the extent practicable, the member must conduct its broker-dealer services in a location physically separate from routine retail deposit-taking activities.
• The arrangement must be governed by a written agreement setting out the parties' responsibilities and compensation and including the broker-dealer obligations in Rule 701 of SEC Regulation R. The agreement must give the member's supervisors, the SEC and FINRA access to the premises where the member conducts business.
• Confirmations and account statements must clearly show that the member, not the bank, provides the broker-dealer services.

Mandatory Customer Disclosures

At or before account opening, the member must disclose in writing that the broker-dealer services are provided by the member and not the financial institution, and that securities products:

1. are not insured by the FDIC;
2. are not deposits or other obligations of the financial institution and are not guaranteed by it; and
3. are subject to investment risks, including possible loss of the principal invested.

For accounts opened on the financial institution's premises, the disclosures must also be made orally. Retail communications that announce the location or promote the institution's name or services, or that are distributed on its premises, must carry the disclosures; the member may use the conspicuous legend Not FDIC Insured • No Bank Guarantee • May Lose Value. The member must also promptly notify the financial institution if it terminates for cause an associated person who is employed by the institution.

Bank Employee Referral Fees (Regulation R)

The limit on referral pay for unregistered bank employees comes from the bank networking exception in the Exchange Act, implemented by SEC Regulation R, rather than from Rule 3160 itself. An unregistered bank employee may refer customers to the broker-dealer and receive only a nominal one-time cash fee of a fixed dollar amount that is not contingent on whether the referral results in a transaction. "Nominal" is measured by pay: no more than twice the average of the minimum and maximum hourly wage the bank sets for the employee's job family (or 1/1000th of that job family's average annual base salary), twice the employee's own base hourly wage (or 1/1000th of the employee's annual base salary), or a fixed inflation-adjusted amount that began at $25. The fee may depend on whether the customer keeps an appointment or meets objective baseline criteria such as minimum assets, but not on whether an account is opened, a security or a particular type of security is bought, or multiple transactions result.

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Referral-Control Workflow

Before approving a referral arrangement, the firm documents the referrer's role, registration status, jurisdiction, customers, communications and payment formula. Legal analysis should address whether the person solicits, recommends, negotiates or participates in execution. A recurring flat fee can still be a problem if its amount or payment effectively depends on securities business.

At a bank location, mystery shopping and branch inspection can test whether tellers stay within permitted referral activity, signs are visible, disclosures are delivered, and securities personnel are distinguished from deposit staff. Customer interviews and compensation data may reveal practices that written agreements conceal.