LEGAL
On July 1, 2015, a new rule issued by the nongovernmental organization Financial Industry Regulatory Authority (FINRA) takes effect. FINRA regulates member brokerage firms and exchange markets, and this new rule – Rule 3110(e) – replaces the "substantially similar" Rule 3010(e) of FINRA's predecessor National Association of Securities Dealers (NASD). The rule requires that "each member firm ascertain by investigation the good character, business reputation, qualifications, and experience of an applicant before the firm applies to register that applicant with FINRA [through the filing of a Form U4] and before making a representation to that effect on the application for registration."
This first portion of the rule's requirements is referred to as the "investigation process." FINRA has explicitly refrained from "plac[ing] any limits on the scope of such a background investigation," instead directing a firm to "obtain all the necessary information to make an evaluation" and "consider all available information gathered in the pre-registration process for this purpose," including Form U4 and Form U5 (Uniform Termination Notice for Securities Industry Registration) responses. The rule also requires that, "if an applicant previously has been registered, ... a firm review a copy of the applicant's most recent Form U5 ... within 60 days of the filing date of the applicant's Form U4."
The second portion of the requirements is called the "verification process," and not only requires firms "to verify the accuracy and completeness of the information contained in an applicant's Form U4 by no later than 30 calendar days after an initial or a transfer Form U4 is filed with FINRA," but also to "adopt written procedures reasonably designed" to do so. These written procedures, which are required to "specify the firm's process for verifying the information in the Form U4," must, at a minimum, "provide for a national search of reasonably available public records." The operative word here is "reasonably," as FINRA states that the term "public records" encompasses a broader swath of records than those that are only "reasonably available" – which FINRA currently understands to "include criminal records, bankruptcy records, judgments and liens." Nevertheless, it is important to note that FINRA states that a firm may be required to do a more in-depth search "depending on the applicant's job function, responsibilities or position at the firm."
The full rule provides more detail about the different ways that a firm could comply with the "reasonably available public records" search requirement, but it's important to note that FINRA does not expect most firms to conduct the verification process in the 30-day window after the Form U4 has been filed. Rather, the 30-day window is an accommodation by FINRA for those "firms that may find it difficult to conduct the verification process before filing an applicant's Form U4, such as where an applicant is hired immediately to fill a needed role at the firm." Considering that there are circumstances contemplated by the rule wherein it may not be possible to complete the verification process within 30 days, firms would be wise to conduct the investigation and verification processes concurrently, rather than waiting after filing to begin verification.
Because FINRA is a private entity, its rules generally do not create a private cause of action. Nevertheless, an organization's failure to act in accordance with FINRA's rules may be taken as evidence of a breach of that firm's duty of care, and consequently, as evidence of negligence. FINRA's legal status as a regulatory agency isn't the only gray area of which to be wary when it comes to this new rule; firms must also be cautious of FINRA's warning that "a firm must obtain all the necessary information" to make their pre-filing background investigations, the scope of which FINRA states that there are no limits.
Thus, because of this ambiguity, companies would be prudent to err on the side of expansive background investigations, lest they be found to have breached their duty of care due to inadequate searches.
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