RCBJ Retrospective: RULE 2040 and the Lawful Payment of Foreign Broker Fees

06.01.15 | Archived

homeirerRULE 2040 and the Lawful Payment of Foreign Broker Fees  (Volume 3, Issue 1, Pgs. 15-16)

by Michael G. Homeier, Founding Shareholder, Homeier & Law, P.C.

As the EB-5 industry becomes better educated about the applicability of (and essential need to comply with) the various U.S. securities laws to industry players and activities, concern has grown about the role of brokers (“broker-dealers” or “BDs”).  BDs are essentially salespersons for securities issuers (including, but of course not limited to, EB-5 issuers), and questions abound about the permissible activities, and lawful compensation, of these salespersons.  Though not unique to EB-5, these questions are particularly acute for the industry because EB-5 usually includes the involvement of foreign persons who bring foreign investors to U.S. issuers and their investment projects, while an increasing number of the latter are engaging US BDs as intermediaries.

Broadly, the Securities Exchange Act of 1934 (the “Exchange Act”) governs the activities of BDs in securities transactions.  Under Section 15(a)(1), the only persons permitted to receive transaction-based compensation (the standard compensation received by BDs in return for referring customers to issuers or other BDs) must generally be registered as BDs, or licensed as associated persons of a registered BD, nowadays usually with the Financial Industry Regulatory Authority (“FINRA”).  Registered BDs are prohibited from sharing their compensation with unlicensed persons, such as the foreign persons mentioned above in an EB-5 transaction.

To further address some of these points, including “fee-sharing” with foreign persons, on December 30, 2014, the U.S. Securities and Exchange Commission (“SEC”) approved FINRA Rule 2040. Prior to Rule 2040’s adoption, FINRA, its predecessor agency the National Association of Securities Dealers (the “NASD”), and the New York Stock Exchange (the NYSE) had all adopted multiple rules and interpretations addressing such payments, and specifically limiting them; these rules and interpretations were in many cases overlapping and duplicative and also differing. The newly-adopted Rule 2040 is intended to consolidate these prior rules and interpretations into one, and “clarify and streamline” the applicable requirements on the topic, rather than to establish new rules.

Rule 2040 generally prohibits any member BD or associated person from, directly or indirectly, paying any compensation to an unregistered firm or unlicensed person, if such compensation would cause the recipient to be required to register under the Exchange Act.  See Rule 2040(a).  Because the SEC holds the position that the receipt of transaction-based compensation triggers the BD registration obligation, receiving referral fees calculated as a percentage of the BD’s compensation, as well as commission sharing, usually means that the recipient must be registered.  Under the Rule, FINRA “members [are expected] to determine [whether the proposed activities of the unlicensed person] would not require the recipients of the payments to register.”  Such a determination is required to be reasonably supported.

Following publication of the proposed Rule 2040 in 2014, commentators raised concerns about the difficulty of making this determination, in particular where the consequences of making an erroneous determination are punitive.  To address these concerns, FINRA added guidance to help BDs determine whether a person seeking transaction-based compensation should be registered. Rule 2040 is accompanied by “Supplementary Material .01” providing interpretive guidance on the provisions of the Rule itself.  FINRA advises BDs to document the basis for determining that a payment may be made to an unlicensed person.  Where BDs are uncertain as to whether an unregistered person may be required to be registered by reason of receiving payments from the member, BDs are advised to secure “reasonable support” for their determination by various means, including among other things: reasonably relying on previously published releases, interpretations, and “no-action letters” (in which the SEC states it will take no action on account of a proposed situation) that apply to their facts and circumstances; (2) seeking their own no-action letter from the SEC staff; or (3) obtaining a legal opinion from independent, reputable U.S. licensed counsel knowledgeable in the area.

Two exceptions to the Rule 2040 prohibition against payments to unregistered persons have been included, essentially carried over from the previously-existing rule structure.  The first exception, Rule 2040(b), allows payment of commissions to retired representatives and will not be further addressed here.

The second exception, the Rule 2040(c) “foreign finders exception,” is highly relevant to the EB-5 industry, because it expressly permits BDs to pay referral fees to non-registered foreign finders for the referral of customers who are foreign nationals.  It is essentially a “carry-over” of prior NASD Rule 1060(b).  For this exception to apply, the U.S. BD must determine that:

  • The foreign finder is not required to register in the U.S. as a BD, is not subject to a statutory disqualification from participation in the securities business, and payment would not violate the laws of the recipient’s home country
  • The foreign finder must be a foreign national or entity domiciled abroad
  • The customers brought to the firm by the foreign finder must be foreign nationals domiciled abroad
  • Those customers must receive specific written disclosure in “a descriptive document,” similar to that required by Rule 206(4)-3(b) of the Investment Advisers Act of 1940, of the fact and amount of compensation for the foreign finder
  • The customers must provide written acknowledgment of receipt of the disclosure in writing, which acknowledgments are retained and available for FINRA inspection
  • Records of the payment of all finder fees must be maintained in the books of the member firm
  • The confirmation of each transaction indicates that a referral or finder fee is being paid pursuant to an agreement.

If all the conditions set forth in the rule are satisfied, BDs can pay transaction-related compensation to non-registered foreign finders based on the business of non-U.S. customers that those finders refer to member BDs.

Importantly, like legacy NASD Rule 1060(b), FINRA Rule 2040(c) only sanctions a foreign finder whose activities are limited to providing an initial introduction, without any further activity.  Any activities beyond the initial referral, and payment of transaction-based compensation for any such activities, would not be within the permissible scope of the foreign finders exception of Rule 2040(c). Concerned commentators have pointed out that if further activities are engaged in by the foreign finder beyond the initial referral (and beyond the coverage of 2040(c)), the finder may need to be registered.

In reply, the SEC has stated that Rule 2040(c) does not address all circumstances under which payments may lawfully be made by U.S. BDs to foreign finders. The Rule carries over a narrow safe harbor that permits a BD to pay on-going compensation to a foreign finder under the conditions set forth in the Rule.  The Agency pointed out that Rule 2040(c) is not intended to be the only means by which a member may pay compensation to a foreign finder. Therefore, BDs may rely on other applicable federal securities laws and regulations where the activities of the foreign finder go beyond the scope permitted by the Rule (e.g., the initial referral of a customer to the member). Examples of alternatives could include (a) restricting all foreign finder activities to being conducted exclusively outside the U.S. (however, this would need to be strictly correct, and is subject to factual challenge), or (b) simply, not having a U.S. registered BD participating, in which case since the FINRA rules govern member conduct, they would be impacted.  (This latter alternative should be weighed very carefully, however, as there can be real safeguards provided and important assistance rendered by U.S. BDs even if their participation is not technically required.)  As always, to identify and properly rely upon such laws, regulations, and alternatives, EB-5 issuers and FINRA member BDs are well advised that the assistance of “independent, reputable U.S. licensed counsel knowledgeable in the area” of broker-dealer registration and practice be obtained prior to any decision being made.

RCBJ Retrospective articles are reprinted from IIUSA’s Regional Center Business Journal trade magazine. Opinions expressed within these articles do not necessarily represent the views of IIUSA and are provided for educational purposes. 


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