3.1 The Supervisory System, Written Supervisory Procedures, and Standards of Conduct
Key Takeaways
Rule 3110(a) requires a supervisory system reasonably designed to achieve compliance, including designated principals, registered OSJs and branches, assignment of every registered person to a supervisor, and an annual compliance meeting.
An OSJ is any office where order execution or market making, structuring of offerings, custody of customer funds or securities, final approval of new accounts, review and endorsement of customer orders, final approval of retail communications, or supervision of other branch offices takes place (Rule 3110(f)(1)).
Written supervisory procedures must list the titles, registration status and locations of supervisory personnel, must be kept at each OSJ and supervisory location, and must be amended promptly when rules or the supervisory system change.
Rule 3110.05 permits risk-based review of transactions, but a principal must still review transactions and evidence that review in writing.
Rule 5270 prohibits trading a security or a related instrument while in possession of material, nonpublic information about an imminent block transaction; FINRA generally treats 10,000 shares or more of an equity security as a block.
Function 2 is the largest part of the Series 26, with 49 of 110 scored questions, and Task 2.1 asks the principal to monitor, supervise and document associated persons' sales activities. The foundation is FINRA Rule 3110. The legal standard is reasonable design: no system catches every violation, but final responsibility for proper supervision rests with the member, and a supervisor who ignores red flags is personally exposed to discipline.
Elements of the Supervisory System (Rule 3110(a))
At a minimum, the system must provide for:
- written supervisory procedures (WSPs);
- appropriately registered principals with authority over each type of business that requires broker-dealer registration;
- registration and designation of each location, including the main office, as a branch office or office of supervisory jurisdiction (OSJ) when it meets the definitions in Rule 3110(f);
- one or more registered principals in each OSJ, and one or more registered representatives or principals in each non-OSJ branch, with authority to carry out that office's supervisory duties;
- assignment of every registered person to an appropriately registered supervisor;
- reasonable efforts to confirm that supervisory personnel are qualified by experience or training; and
- an annual compliance meeting or interview for each registered representative and principal (Section 2.1).
Offices of Supervisory Jurisdiction (Rule 3110(f)(1))
An OSJ is any office where one or more of these functions takes place:
| OSJ function | Packaged-product example |
|---|---|
| (A) Order execution or market making | Rare at fund distributors |
| (B) Structuring public offerings or private placements | Rare at fund distributors |
| (C) Maintaining custody of customers' funds or securities | A cash cage holding customer checks |
| (D) Final acceptance (approval) of new accounts | A principal signing new account forms |
| (E) Review and endorsement of customer orders | Daily principal review of mutual fund and VA trades |
| (F) Final approval of retail communications | Approving a seminar flyer, other than offices that only approve research |
| (G) Supervising associated persons at one or more other branch offices | A regional office overseeing several branches |
Supplementary material adds detail. .01: the main office must be registered as a branch or OSJ if it meets the definitions. .02: firms should designate additional OSJs where needed, considering factors such as retail customer contact, number of registered persons, geographic distance and the complexity of the business. .03: there is a presumption against one principal serving as the on-site principal for more than one OSJ. Because an on-site principal must have a regular physical presence, assigning one principal to several OSJs requires documented justification. Section 10.1 covers branch and non-branch locations and the residential supervisory location.
Written Supervisory Procedures (Rule 3110(b))
The WSPs must be tailored to the firm's actual business and must include:
- (b)(2) procedures for review, by a registered principal and evidenced in writing, of all transactions relating to the investment banking or securities business;
- (b)(4) review of incoming and outgoing correspondence and internal communications (Section 4.4);
- (b)(5) procedures to capture, acknowledge and respond to all written customer complaints (Section 11.1);
- (b)(6) the titles, registration status and locations of supervisory personnel and each person's responsibilities, with a record of all designated supervisory personnel and their effective dates kept for three years, and procedures addressing conflicts in the supervision of supervisory personnel (Section 9.1); and
- (b)(7) a copy of the WSPs, or the relevant portions, kept at each OSJ and each location where supervisory activities occur. The firm must promptly amend the WSPs when laws or rules change or its supervisory system changes, and promptly communicate them to the associated persons they apply to.
Rule 3110.11 allows WSPs to be communicated electronically. The procedures must be readily accessible, amendments promptly posted, affected persons notified of changes, the posted material secured against unauthorized alteration, and current and prior versions retained under SEC Rule 17a-4(e)(7).
Risk-Based Review (Rule 3110.05)
A principal must review every transaction, but Rule 3110.05 lets the firm use a risk-based review system. Detailed review of each transaction is not required if the system gives the firm enough information to focus on the areas that pose the greatest number and risk of violations. Typical packaged-product exception reports include:
- Class A purchases just below a breakpoint and C-share purchases in large amounts (Section 5.3);
- mutual fund switches and variable annuity exchanges, including the 36-month exchange look-back (Section 5.4);
- concentrations of complex or illiquid products and transactions involving customers 65 or older; and
- address changes followed closely by disbursements (Section 9.1).
The reviewer must understand the report's parameters, follow up on red flags, and document the resolution. Merely clearing alerts without inquiry is not a reasonable review.
Transaction review for insider trading (Rule 3110(d)) requires procedures to review trades in firm accounts, accounts in which associated persons have a beneficial interest or trading authority, outside accounts disclosed under Rule 3210, and covered accounts of associated persons' spouses, dependent children and similar relatives, and to investigate promptly any trade that may violate insider trading or manipulation prohibitions (Section 3.2).
Conduct and Antifraud Standards
| Provision | What it prohibits or requires |
|---|---|
| FINRA Rule 2010 | Members and associated persons must observe high standards of commercial honor and just and equitable principles of trade. It reaches unethical conduct, such as forging a customer's signature even with the customer's permission, without a more specific rule. FINRA routinely treats any rule violation as a Rule 2010 violation as well. |
| FINRA Rule 2020 | Effecting or inducing transactions by means of any manipulative, deceptive or fraudulent device |
| Exchange Act Section 10(b) and Rule 10b-5 | Fraud and material misstatements or omissions in connection with the purchase or sale of any security |
| Exchange Act Section 15(c)(1)-(2), Rules 10b-3, 15c1-2 | Manipulative, deceptive or fraudulent devices and fictitious quotations by brokers and dealers |
| Rule 15c1-3 | Representing that SEC registration of a broker-dealer means the SEC approved its financial standing, business or conduct |
| Securities Act Section 17(a) | Fraud in the offer or sale of securities |
| Securities Act Section 12 | Civil liability: rescission for sales that violate Section 5, or by prospectus or oral communication containing a material misstatement |
| Securities Act Section 23 | Representing that an effective registration statement means the SEC found it accurate or passed on the merits |
| 1940 Act Section 37 | Larceny or embezzlement of an investment company's assets is a federal crime |
Front Running (Rule 5270)
Rule 5270 prohibits a member or associated person from causing an order to be executed in a security, a related financial instrument (such as an option or other derivative overlying it), or a security underlying a related instrument, while possessing material, nonpublic market information about an imminent block transaction, until the block information is public or stale. The prohibition covers accounts in which the member or person has an interest or exercises discretion, and customer or affiliate accounts that received the information from the member.
- Rule 5270.03: a transaction of 10,000 shares or more of an equity security is generally treated as a block, though smaller trades can qualify.
- Rule 5270.04: permitted transactions include those the member can show were unrelated to the information, such as trades behind effective information barriers, trades for prior customer orders, bona fide error corrections, and trades that facilitate the customer's block order with the customer's consent.
- Rule 5270.05: front running non-block orders may still violate Rule 2010, Rule 5320 or the federal securities laws.
Conflicts of Interest
The outline asks for knowledge of "regulatory requirements to manage conflicts of interest." In the packaged-product business, the main tools are:
- Reg BI's conflict of interest obligation, which requires identifying, disclosing or eliminating conflicts and eliminating sales contests based on specific securities (Section 5.1);
- Rule 2341(k), which forbids favoring a fund family because of brokerage commissions directed to the firm;
- the cash and non-cash compensation rules (Sections 6.1 and 6.2); and
- Rule 3110(b)(6)(D)'s requirement that supervision not be compromised by a supervisor's financial interest in the person supervised.
Which activity, by itself, makes a branch an office of supervisory jurisdiction under Rule 3110(f)(1)?
Registered representatives regularly meet customers there by appointment
The office handles customer complaints by forwarding them to compliance
A principal at the location gives final approval to new customer accounts
Representatives at the office mail approved fund literature to prospects
A firm revises its written supervisory procedures after a new FINRA rule takes effect. Which statement describes Rule 3110(b)(7)?
Only the chief compliance officer must have access to the current WSPs
The WSPs need to be updated only once a year, during the Rule 3120 testing cycle
The firm must promptly amend its WSPs to reflect rule changes and promptly communicate the amendments to the associated persons they apply to
The WSPs must be filed with FINRA within 30 days of each amendment
A registered representative learns that an institutional client is about to sell 80,000 shares of a closed-end fund in a single negotiated trade. Before the client's order is executed, the representative buys put options on the fund for a personal account. Which rule most directly prohibits this?
Rule 3230, because the representative used customer contact information
Rule 2111, because the trade was unsuitable for the representative's own account
Rule 2210, because the trade was not disclosed in any communication
Rule 5270, because the representative traded a related financial instrument while possessing material, nonpublic information about an imminent block transaction
Sections you finish are checked off in the contents.